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How to Focus on Tax Efficiency with Your Portfolio


Tax is a three letter word that sounds a lot like a four letter word to many people. Of course, everyone has to pay their taxes but minimizing the impact of taxes is a very important part of investing for many people. Why pay money to the government if you don’t have to, right?
Creating a tax efficient portfolio is not always top-of-mind for some investors as they enter the market. Many investors learn about tax efficiency after it’s too late and they are on the hook for capital gains as a result of their investments.
What’s even more shocking is when these capital gains arise even without selling or trading any shares.Exchange traded funds (ETFs) and mutual funds can incur capital gains taxes and, since the tax burden can’t be held inside the fund, those gains must be passed along to investors. For investors that are not prepared, this can be an unwelcome shock to their finances especially since they have not actually realized any gains themselves while their money is still invested in the fund.
This article will focus on how to plan for tax efficiency with your portfolio as well as some hidden taxable situations that you can prepare for before they surprise you during tax season.

Why is Tax Efficiency Important?

Many people begin their investing journey by contributing to a 401k and/or and IRA. These are both known as tax advantaged accounts, which means that taxes are either not applicable. Or they could also be deferred until withdrawal later in life when investors would presumably have a lower income – and, in turn – a lower tax burden.

However, the limits for these investments often don’t meet the needs of investors who want to save for a solid financial future. Since investors have contribution limits, they need to look beyond tax advantaged accounts. This is where tax efficiency must become an important consideration when investing.

Taxes on non-tax advantaged accounts can quickly begin to eat away at gains and set your investment success back. For any investor to be successful, they must at least consider the implications of taxes on their investments and how they will either manage those taxes or reduce tax implication through tax efficiency.The first step in planning for tax efficiency is to understand how taxes can be accrued.

How Do Exchange Traded Funds and Mutual Funds Incur Taxes?

Many investors with long term goals take a “set it and forget it” mindset towards their investing. They choose an ETF or mutual fund that meets their investment goals and timelines, then sit back and let their money go to work for them.

This is the old saying, “time in the market beats timing the market” put into action.However, even though investors may be relatively hands off with their investments, the funds may be doing a lot of work behind the scenes to deliver the results that investors expect. To do this, fund managers will sell, trade, and purchase assets as they see fit. This is where capital gains taxes may come into play for investors.If an asset is sold for a gain, the fund will incur capital gains on that asset.

However, an ETF or mutual fund can’t simply absorb taxes and, as a result, those taxes must be passed on to investors in the fund. This is why investors who take a patient approach to their investments may be shocked by taxes incurred from sales made by the fund manager.

The good news is that taxes are not incurred until gains are actually realized by selling assets. Market gains on paper are unrealized gains and, therefore, are not taxed until a sale is made.
Investment funds that take a passive approach to investing will make fewer trades and, ultimately, pass along less tax considerations to investors when compared with a more actively managed fund.

How Do Individual Investors Incur Taxes?

Investment fund managers aren’t the only ones that can incur tax burdens for investors. Sometimes, when it comes to tax efficiency, investors are their own worst enemies. Without proper planning and sticking to the right plan, investors can incur significant tax bills that ultimately chip away at their gains.

The most common reason an investor will incur taxes is by selling investments. This is why a passive investment strategy is often the best choice for those who want to reduce their tax commitment when it comes time to file. Even selling one investment to move into another investment could be a taxable situation if a capital gain was realized on the original investment that was sold.

How Can Other Investors Affect Your Taxes?

You have chosen the right tax planning strategy, you have found the right fund for your needs, everything should be perfect, right?
Well, not so fast. Other investors, people you have never met, could actually have an impact on your taxes. How is this possible?

When you invest in a mutual fund, you are one of many investors. The decisions of the other investors in the fund could have implications on the taxes and fees incurred by the fund.
For example, if a large number of investors were to leave the fund then the fund manager would have to sell assets in order to cash out investors. As a result, there could be capital gains taxes which would then be passed onto investors. This would be in addition to fees that could also be a result of large investor movements.

A large number of buyers entering the fund could also cause existing investors to be on the hook for taxes and fees as the fund manager acquires assets with the new money entering the fund.
Depending on how the fund manager chooses to balance the assets and if any selling of assets is required, taxes and fees could be incurred.

Beware of Herd Mentality

As you can see, with mutual funds, herd mentalities among investors can affect the tax burden of other investors. Even with the best laid tax efficiency plan from individual investors as well as fund managers, herd mentalities can still have a negative effect on tax planning.

These herd mentalities can be most prevalent during times when markets are growing rapidly or declining rapidly. Investors move their money around to try and time market behaviors which, ultimately, can leave other investors in a poor situation come tax season even if that investor did nothing to change their investment habits.

Why Investors Choose Exchange Traded Funds for Tax Efficiency

In recent years, exchange traded funds have seen a meteoric rise in popularity among investors. There are many reasons for this. One of the most common reasons people are choosing to invest in ETFs is because of tax efficiency. On the surface, an index mutual fund and an index ETF may look very similar. They could track similar industries, hold a similar balance of assets in the fund, and deliver similar returns.

Why are so many investors drawn toward the ETF option?

Tax efficiency is one of the greatest differentiators between an index mutual fund and an ETF. The main reason for this is the way that trades and asset management work within each fund.
In the previous section, you learned about how a herd mentality could affect even the most conservative mutual fund’s tax considerations. The way that ETFs are bought and sold is different than the way that mutual funds are bought and sold by individuals.

How ETFs Are Bought

When an investor buys into a mutual fund, the fund must purchase assets to reflect the new investment they hold. They may have to sell assets and rebalance, if needed. If that investor chooses to sell, then the mutual fund may have to sell assets in order to pay out the leaving investors.

Both scenarios can have tax implications for all investors in the fund.An exchange traded fund is an index fund that is traded more like an individual stock. This is a massive fundamental difference between mutual funds and ETFs. Since individuals can trade shares in an ETF on the market between each other, sales and purchases are between two individuals. That means that the fund does not actually have to sell assets itself in order to manage incoming and outgoing investors. As a result, investors in the fund do not find themselves responsible for capital gains taxes. Of course, if a fund manager chooses to rebalance the fund in order to best meet the original goals of the fund, there may be tax implications based on the selling and buying of assets within the fund. However, this gives managers much more control over the tax implications that will be passed along to investors. Hence, investors can make more educated decisions if tax efficiency is important to them.

Ability to Acquire New Assets

Exchange traded funds also have another mechanism by which they can acquire new assets. Instead of selling assets to rebalance, which would potentially incur capital gains taxes, ETFs can issue a creator’s block of shares to exchange with an authorized participant in return for shares in companies that the ETF is interested in tracking. The authorized participant acquires the shares that the fund requires and trades them at one to one value in return for the creator’s block of shares.

This exchange means that no capital gain has been realized and shields investors from tax implications. In addition, the authorized participant usually manages the fees associated with the purchase of the equities required so ETFs can maintain a low fee structure for investors.

Why does an authorized participant take on this role? They receive the ETF shares at the net asset value (NAV) rather than the market price. As a result, they may be able to immediately turn around and sell the ETF shares on the open market for a profit. All of this is very efficient for ETF managers who are often very cognizant of the taxes and fees they pass onto investors.

Which Tax Efficiency Plan is Right for You?

As with most investing concepts, it’s impossible to simply prescribe a one-size-fits-all tax efficiency plan to all investors. Some investors will be much more wary of the effect that taxes can have on their investments while others may be willing to accept taxes in return for substantial gains.As a general rule of thumb, investors should always maximize their tax advantaged accounts first. Once that is done, then investors should look to supplement their investments with non-tax advantaged accounts. From there, tolerance for taxes will depend on the individual investor.

However, many investors are generally wary of paying additional taxes if they absolutely can avoid doing so. Mutual funds and exchange traded funds are both great vehicles for long term investing. However, exchange traded funds do offer some tax efficiency benefits that mutual funds do not. This does not necessarily mean one is better than the other as there are a variety of other factors that should be taken into consideration before investing.

However, for the tax conscious investor who wants the smallest tax burden come tax season, exchange traded funds with a low turnover ratio may be the best choice for tax efficiency. In down markets, this may be especially true as the herd mentality drives some investors to sell assets in an attempt to cut their losses.


Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

If you have more questions about tax efficiency, exchange traded funds, and investing in general; please contact Linden Thomas and Company.

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