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The Tax Issues That Come with Index Funds

02/13/2019

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There are a number of tax advantages that come from holding index funds, but there are also disadvantages associated with the same financial vehicles. In this article, we’ll discuss some of the key points to keep in mind while moving forward with your tax planning using financial vehicles like index funds.
The tax advantage to index funds is associated with the lack of trading that takes place with stocks in the fund. Trading is generally low whether you are dealing with a mutual fund or an exchange traded fund (ETF).
On the other hand, there is a tax downside to owning an index fund too. This comes in the form of capital gains from the fund. Basically, capital gains usually mean taxes. You are responsible for any of the taxes that build on any capital gains you receive.
Additionally, it does not matter when you bought into the fund. Whether you bought in a few days or a few years ago, you will need to pay capital gains taxes all the same. Hence, you could owe capital gains taxes despite investing in the index for a short period of time.

Why and How Do I Get Hit with Capital Gains Taxes?

Even if you do not receive capital gains regularly, such as monthly, you will still have to deal with any tax on capital gains, especially embedded capital gains.

Embedded capital gains come from owning the stock in the index for a long time. The long term capacity of keeping securities in your portfolio, even in an index fund, builds embedded capital gains. These gains are, again, taxable gains.

Owning securities, even opting into an index fund for long periods of time, will build embedded capital gains, which are taxable earnings. You will need to pay those taxes to maintain your share position in the index in the long term.

There are a few interesting cases to explore when it comes to capital gains taxes.

Cases of Capital Gains Taxes

For example, on a pre-tax basis, a mutual fund’s capital gains distribution should be valued neutral. However, you will pay tax on those capital gains, even embedded gains. The amount of tax you need to pay will depend on the tax bracket that you are placed in.

You are following the trading patterns of a fund manager when investing in a mutual fund, so any outflows or inflows of assets will have tax implications. Taxes will follow capital gains wherever they are available, including the flow of assets in and out of a mutual fund.

Funds Following Indexes Lead to Taxes

Funds that follow indexes with swaps, options, futures contracts, and other indirect techniques can lead to tax issues too. The extra trading involved with moving so many kinds of assets around will create capital gains, and, in turn, more taxes.

The basic idea is if there is a higher movement of securities within a fund then there are more frequent taxes associated with that fund.

ETFs Are Less Tax Heavy Funds

There are fewer tax issues with exchange traded funds (ETFs) even though these funds are also modeled after indexes. This is mainly due to the structure behind ETFs.

However, there are tax issues that come up in certain international ETFs, especially those that focus on emerging markets.

Unlike other ETFs, emerging market ETFs focus on in-kind deliveries of securities, which are able to take out a large percentage of your capital gains for tax purposes.

Issues with Emerging Market ETFs

The draw toward emerging market ETF securities grew when the housing market started to improve following the 2008 financial crisis.

As an example, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), and Government National Mortgage Association (Ginnie Mae) backed residential MBS underwriting surged from $1.1 trillion to $1.7 trillion in just a year. This took place from 2008 to 2009, just after the first year of the financial crisis.

The housing improvements flooded the market with new issuances and all the relevant indexes updated their holdings accordingly. The change led to extreme trading, which was followed by the associated capital gains, and that led to higher taxes.

The number of ETF-distributed capital gains kept growing from 2008 and onward, which continued after the financial crisis too. The taxes kept under the emerging market ETFs grew along with any capital gains.

Some large inflows into these indexes, but coupled with low supply, can result in high turnover rates. When there are not enough securities available in indexes then ETFs are forced to do cash creations and redemptions rather than in-kind processes – again, another buildup of capital gains, which can result in higher applied taxes.

ETFs With Bond Securities in The Long Term

The non-traditional bond category has a number of ETFs to choose, and many of them offer dividend payments. However, these payouts are also taxable. The combination of high turnover coupled with earnings brings up capital gains.

As an example, ProShares Inflation Expectations Fund seeks to provide exposure to 30-year treasury inflation-protected securities. These give out derivatives that are short-lived and need to be replaced with new contracts to maintain exposure.

However, the same derivatives create capital gains for the investor and that exposes the investor to further taxation issues.

Another example, WisdomTree Barclays Interest Rate Hedged U.S. Aggregate Bond Fund uses derivatives too. These derivatives provide for exposure to an index. Similarly, long exposure to securities like treasury bonds with turnover of derivative holdings tends to bring up capital gains. These derivatives are also taxable, and adds an additional lump sum to tax owed.

ETFs with Bond Securities in the Short Term

Short-term ETFs in the bond category need to regularly purchase new holdings because maturity dates come around quickly. The short maturity time exposes investors to rapid gains, and those, again, are taxable. The tax burden on investors tends to build up quickly.

An example in the short-term bond market category, the Vanguard Short-Term Bond ETF follows the Bloomberg Barclays U.S. 1-5-Year Government/Credit Float Adjusted Index. The index holds bond securities with fast maturity times, those that are under five years. Earning capital gains on maturity of these bonds and then replenishing the ETF with new ones tend to create additional taxes for investors.

Vanguard launched its fund in 2009 and has paid out capital gains almost every year since 2009.

However, Separately Managed Accounts (SMA) that replicate an index tend to bring on the least tax burden. Investments in these accounts are held individually. They are only sold when there is a change in the index being tracked.

If sales of account securities were the only trigger to capital gains, then the infrequent selling works in favor of the investors. The advantage comes in the form of a lesser tax burden, since capital gains taxes accrue less frequently.

An investor can still hold a larger scope of wealth in terms of account securities without worrying about a tax burden in the short term.
An additional benefit is that there is choice involved in buying or selling securities in a SMA. Investors can opt to claim capital gains at their convenience, but tax will be applied on those gains.

Final Review of Tax Burden Due to Capital Gains

There are a lot of taxes that can pile up from capital gains earned in a number of ways, including holding securities or liquefying assets.

However, along with being able to accrue taxes, there are ways to limit your exposure to them. One way of limiting tax exposure with index funds and ETFs is to focus on less trading and security allocation. One of the key disadvantages to frequent trading and other movement of securities is the buildup of taxes over time. The movement of securities into and out of the fund is associated with gains, which trigger more taxes.

Additionally, it may be a smarter move to hold on to securities in the longer term. If securities, such as bonds, take longer to mature then there are fewer taxes that need to be paid.

DISCLOSURES

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.

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