Buy ETFs to Beat The Tax Man

Both Vanguard and iShares have recently posted preliminary capital gains estimates that include only a small percentage of funds that are mostly fixed-income related.  The widely held iShares Aggregate Bond ETF (AGG) and Vanguard Total Bond Market ETF (BND) are on the list with very minimal capital gains distributions that amount to only a few pennies.

A look back at equity oriented ETFs such as the iShares S&P 500 ETF (IVV) or the Vanguard Total Stock Market ETF (VTI) shows that neither of these funds has paid a distribution other than ordinary dividends for as long as the company has posted data.  This is mainly due to the fixed nature of the underlying index which dictates that the ETF hang onto the same stocks for long periods of time.  This makes them extremely tax efficient for your portfolio no matter when you purchase them.

Even an actively managed ETF such as the PIMCO Total Return Fund (BOND) which has a much higher degree of portfolio turnover, is only anticipating a short-term capital gain of $0.41 per share.  That equates to just 0.39% of its current NAV.

While the majority of ETFs are tax efficient, it still pays to research your options and key in on any potential red flags.  One of the hidden pitfalls of investing in certain commodity-related ETFs is the tax ramifications of their legal structure. What I am talking about here is the difference between an ETF that is structured as a trust that generates a 1099 vs. being structured as a partnership that generates a K-1.  The addition of a K-1 creates a headache for taxable accounts that must be dealt with on your year-end tax return.  To avoid that mess, you can often times find a similar commodity index in an exchange-traded note.

I never recommend investing solely with taxes in mind, but it does help to understand some of the ramifications that can occur without solid due diligence.  It’s all about the right timing and security selection to meet your goal and avoid any unintended tax burdens.   For the most part, ETFs offer an efficient way to reduce the impact of long-term capital gains for new money that you are looking to put to work this year.