As investors, we’re often concerned about the bite taxes take out of our portfolios. But the fear of taxes has a downside. You may be settling for lower after-tax returns in order to pay less in taxes. That’s an important consideration when it comes to investing in exchange traded funds, which are often touted for their tax efficiency.
“When investors are selecting the most tax-efficient investments, they can be acting like the guy who declines a $1,000 raise because he doesn’t want to pay $200 in taxes,” said Joel Dickson, a principal in Vanguard’s Investment Strategy Group.
“Sometimes, paying more in taxes means getting more and paying less in taxes means getting less,” he said. “It’s not how much you pay—it’s how much you keep.”
Mr. Dickson said the confusion arises from attempts to capture tax efficiency. “The return an investor ultimately receives is net of expenses, net of taxes owed on dividend and interest income, net of taxes owed on capital gains distributions, and net of taxes owed upon the sale of the investment, if it has appreciated. Yet many of the measures investors and financial advisors rely on to gauge tax efficiency aren’t looking at the entire picture.”
Mr. Dickson suggested looking at an investment’s after-tax return to get a fuller picture of the real return an investor will receive. He offered the following example to illustrate his point:
ETF A and ETF B have the exact same investment portfolio. Both portfolios generated a 2% dividend yield and an 8% one-year return before expenses. But the ETFs have different expense ratios, resulting in different returns for investors.