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Is Your Mutual Fund Tax Efficient?

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Well, it’s that time of year again.

That time when mutual fund companies report distributions for capital gains taxes. Just in time for the holidays and a total buzzkill on all of that discretionary spending you planned on participating in. 

“But I’m in a Buy & Hold portfolio and didn’t sell. How can I have a taxable gain?” Ah, this is where one of the (many) hidden flaws of investing in mutual funds comes into the picture. It’s not about what you, the investor and shareholder, buy and sell. It’s about what happens behind the curtains of the fund you’re invested in. Probably not something your advisor has taken the time to explain to you.

 A capital gains distribution is a payment to shareholders that is prompted by a fund manager’s liquidation of underlying stocks and securities in a mutual fund or derived from dividend and interest earned by the fund’s holdings minus the fund’s operating expenses. Further, these distributions must be made because tax law dictates that substantial portion of investment income and capital gains must be paid to investors.

“But my return on the fund is essentially flat (or negative) for the year. Why is the distribution so high?”

Again, this is one of the most frustrating things about mutual funds and why they are, for the most part, terribly inefficient from a tax perspective. Regardless of how long the investor owned the fund, the distributions are taxed based on how long the fund itself held the sold holdings.

Can you imagine owning a fund that returned 1-2% in 2018 and being told you are going to get hit with a 10% (or even larger in some circumstances) taxable event? It’s not even your choice. Was your “buy and hold” game plan specifically built to be tax-conscious? Well, maybe in theory it was. But reality is different. Even many Vanguard mutual funds are paying massive distributions in 2018. This is a big deal for investors with assets in accounts that aren’t a 401(k) or IRA.

In an excellent piece by Christine Benz earlier this month, she points to the fact that “many mutual funds are likely to dish out capital gains distributions that are on par with–or even higher than–years past adds insult to injury.” Mutual funds that need to raise cash can sell profitable investments and create capital gains for investors, even if the fund has performed poorly. This means you can lose money on an investment in a mutual fund but still end up owing taxes. As I mentioned above, capital gains in a mutual fund get passed along to its investors.

Related: The 2019 Contribution Limits Are Here!

An interesting article put out by ETF Trends states that ETFs have tax efficiency built into the structure. The “exchange traded” attribute of the ETF structure allows investors to purchase and sell shares without creating or redeeming small odd-lots. This is very different from mutual funds where every day mismatched buyers and sellers force transactions and tax implication in the underlying fund. The tax implications from these transactions become liabilities to those still holding the mutual fund shares. Furthermore, the creation and redemption process, which allows for in-kind transaction with Authorized Participants (APs) can further reduce the likelihood of creating a distributable capital gain in the ETF structure.

With all this said, I again point to the fact that ETFs, particularly from a taxable income standpoint, are much more optimal for investors over the long term. There are plenty of other arguments (closet indexing, high(er) fees, diversification, etc.) of why we continue to promote the use of ETFs over mutual funds, but tax consequences are by far one of the top reasons we advise clients to steer clear. Forget Sharpe Ratios and standard deviation statistics, if you want to talk about risk…it’s simply not worth the risk of getting hit by a major taxable event. Remove those possibilities from your game plan and look to ETFs as the proper vehicle to reach the goals you’ve set for your portfolio.

If you would like to have your portfolio analyzed for fees and tax efficiency schedule a time to chat with us here 

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