By Ryan Gilmer, CFA – VP Investment Management – TOPS ETF Portfolios
Index based ETFs have significant advantages over many actively managed mutual funds, including lower costs, less tracking error, and more transparent trading. This time of year, when many mutual funds are making year end capital gain distributions, it’s good to be reminded about another benefit of ETFs – their tax efficiency.
Source: American Funds, Fidelity, T. Rowe Price, MFS, Oakmark, and Morningstar. If distribution given as a range, midpoint is used. Distributions are estimates based on NAV at 10/31/17 of A shares. MFS estimated capital gains as a percentage rather than per share amount.
In contrast, the following chart shows distribution estimates for some of the largest equity ETF products:
Source: iShares, Vanguard, Morningstar.
Investors report capital gain distributions on their tax returns in the year they are paid out by the fund company. Consider a hypothetical investor with a taxable account subject to a 20% tax on his capital gains. While capital gains rates vary based on individual circumstances, high income or high net worth investors may have an even higher rate. Let’s say that investor receives 5% of his investment as a capital gain distribution from his mutual fund. After paying a 20% capital gains tax, he has lost 1% of his investment to taxes, which decreases his after-tax performance. If this process repeats in subsequent years, compounding the impact, it’s not hard to see how this can negatively affect his investment results.
In this example, both funds earn an 8% pre-tax rate of return. The mutual fund investor, however, because of the 5% distribution and his 20% assumed capital gains rate, only makes 7% after taxes. Assuming this continues for ten years, the difference between the ETF and mutual fund portfolio is over $191,000. For higher net worth investors in higher brackets, the difference could become even more pronounced.
In theory, an ETF investor can defer capital gains in perpetuity. If he never sells, he never has to pay tax. In practice, many investors will decide to sell their ETFs and will realize gains at that time. Again, however, it’s important to note there are still many instances where investors may not ever pay capital gains tax. For example, if an investor holds ETFs until their death, under current law their beneficiaries will receive a step up in basis as of the date of death. If an investor decides to donate shares of an ETF to charity, under current law he will also avoid payment of capital gains taxes. There may also be opportunities in retirement, when many investors have lower tax brackets, to sell portions of their investment at decreased tax rates. In any event, the tax efficiency of ETFs puts the control of these decisions with the investors and their tax professionals, rather than with portfolio managers.
Many of us already receive unwanted gifts this holiday season. You can avoid another gift you didn’t ask for by adding exposure to a tax efficient ETF portfolio.
This article was written by Ryan Gilmer, CFA, who is Vice President – Investment Management at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.
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This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.
Diversification cannot assure gains or protect against losses.
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Source: Bloomberg for historic price and return references. TOPS® is a registered trademark of ValMark Advisers, Inc.