According to some recent analysis by our marketing team, our clients are less likely than average to open emails that have the word “tax” in the subject line. I thought about that fact when writing the title of this post – if people knew that the topic was tax efficient investing, would they be less likely to continue reading?
It’s understandable to have a strong aversion to the T-word, especially if you’re still reeling from the bill you had to pay last April 15th. But that’s exactly why it’s better to address tax efficiency head-on and year-round, rather than waiting for a certain time of year when, frankly, it may be too late to do anything about it. If you’re not consistently investing with an eye toward tax efficiency, chances are there’s a “hole” in your investment bucket.
Simply stated, taxes can have quite a negative impact on your portfolio’s return. Just look at the illustration below, which shows the hypothetical growth of a $100,000 portfolio returning 4% per year. Even a relatively conservative 1% tax cost can cause leakage in returns, preventing you from keeping more of what you earn.
So how do you go about patching that hole in your bucket? First and foremost, it’s important to understand that not all investments are created equal from a tax-efficiency standpoint. This is where many ETFs can have an advantage, because if they’re benchmarked to an index, the portfolio turnover tends to be relatively low. The less selling that goes on in the fund, the fewer the opportunities for capital gains to be realized.
Also, a stand-alone ETF structure is generally considered to be relatively tax-efficient. An ETF is bought and sold on an exchange, which means that if a large number of investors wish to sell their shares, they simply sell to willing buyers. If there’s significant selling pressure in a traditional mutual fund, it can force the manager to sell securities in order to come up with cash for the redemptions. For a comprehensive list of differences between ETFs and traditional mutual funds, click here.
In addition to being proactive about the tax efficiency of your investments, there are also tax strategies you can employ year-round that may reduce your overall liability come April 15th. A common one is tax loss harvesting – identifying positions to sell at a loss in order to offset gains in the same portfolio. This offset can only be done if the investor refrains from purchasing the same security within 30 days of the sale, but if you want to maintain exposure to the same asset class during that 30-day period, you may be able to do so with a highly correlated ETF [i]. The iShares Correlation Calculator is a great tool for employing this strategy.
Over the next few months, I’ll be sharing more about tax efficient investing and strategies to help guide you through the end of the year. Let me know in the comments section if there are any tax-related topics you’d like me to address!
Sue Thompson, CIMA, is the iShares Head of Registered Investment Advisor Group.
[i] The Internal Revenue Service has not released a definitive opinion regarding the definition of “substantially identical” securities and its application to the wash sale rule and ETFs. The information and examples provided are not intended to be a complete analysis of every material fact respecting tax strategy and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy.
iShares Funds are obliged to distribute portfolio gains to shareholders by year-end. These gains may be generated due to index rebalancing or to meet diversification requirements. Trading shares of the iShares Funds will also generate tax consequences and transaction expenses. Certain traditional mutual funds can be tax efficient as well.
BlackRock does not provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.