After a challenging year, investors can utilize an effective tax management process with exchange traded funds to potentially assist in adding additional value to investment portfolios.
In the recent webcast, Seek to Minimize Your Clients’ Tax Bills With ETFs, John Q. Frank, head of ETF specialists at Invesco, outlined two ways to help your clients keep more of what they earn. Firstly, consider tax loss harvesting opportunities as record losses across asset classes mount in client portfolios. Secondly, prepare to act on capital gain distribution notices as investment managers announce 2022 distributions.
Frank explained that through the tax loss harvesting process, investors would sell underperforming investments at a loss. Investors would then use capital losses to offset capital gains and/or ordinary income. If losses exceed gains or there are only losses incurred, up to $3,000 can be used to offset ordinary income in the current year. Any amount above $3,000 can be carried forward for use in future years. Lastly, to maintain clients’ existing asset allocation or invest in an idea you have, consider exchange traded funds, mutual funds, or other strategies.
It is also important to note that when using the tax loss harvesting strategy, the Internal Revenue Service has guidelines commonly referred to as the “wash sale” rule. In short, it outlines that investors cannot buy a “substantially identical” security 30 days before or after the sale of the funds chosen when conducting tax loss harvesting. This can potentially be avoided by buying a new or different exchange traded fund, mutual fund, or security within a similar industry, Frank added.
Frank pointed out that tax loss harvest opportunities abound as 93% of equity ETFs and 97% of fixed income ETFs have suffered YTD losses.
Frank also warned that as we head toward the end of the year, investors should be ready for fund-driven capital gains distributions that can affect existing fund holders, especially for traditional mutual fund investments. Capital gains distributions are common and can be a noticeable portion of an investment, especially for mutual funds — the percentage of U.S. equity mutual funds that paid capital gains distributions in 2021 was 78%, compared to 7% for U.S. equity ETFs. The taxes on capital gains distributions can erode potential returns over time.
Based on Invesco’s 2021 tax conversations, Brad Smith, director of ETF research at Invesco, highlighted that 99% of portfolios had a publicly announced capital gain distribution for at least one holding and 40% had a capital gain distribution greater than 15% of NAV for at least one holding.
“We review and do our research Based on the funds you provide, we research tax loss harvesting and capital gains opportunities for you,” Smith said.
“We share insights with you We will provide analysis on potential opportunities for you to consider based on our latest information.”
As investors prep for the tax season ahead, Nick Kalivas, head of factor and core equity ETF product strategy at Invesco, underscored three potentially effective ways to minimize the cost of taxes with tax-efficient ETFs. Firstly, replace investments that have high fees, high capital gains distributions, and underperform with ETFs. Reduce exposure to repeat offenders and consider reallocating a portion to ETFs. Lastly, potentially adjust future investment allocations to ETFs.
Kalivas advised investors to start by reviewing the Morningstar style box of the fund to match the style box of an ETF to avoid capital gains distributions or pursue tax loss harvesting opportunities.
Kalivas noted that Invesco offers tax-efficient ETFs that haven’t paid a single capital gains distribution since inception, with 184 Invesco ETFs that have not paid capital gains distributions in the past five years.
For example, in the large-cap category, the Invesco S&P 500 Pure Value ETF (RPV), the Invesco S&P 500 Equal Weight ETF (RSP), and the Invesco NASDAQ 100 ETF (QQQM) can be used as alternatives for the value, blended and growth styles, respectively. Each of the listed ETFs have exhibited 0% average capital gains distributions since inception as well.
Kalivas also highlighted something like the Invesco Russell 1000 Dynamic Multifactor ETF (OMFL) as a substitute to active management. The ETF is indexed factor rotation based on objective economic and market analysis, and it is a tax-efficient ETF structure.
OMFL seeks to track the investment results of the Russell 1000 Invesco Dynamic Multifactor Index. This underlying index is designed to select equity securities based on value, momentum, quality, low volatility, and size factors from within the Russell 1000 Index.
Financial advisors who are interested in learning more about ETF investment strategies can watch the webcast here on demand.