I seek to eliminate many of the problems common in the financial industry: conflicts of interest, excessive fees for advice, and significant investment fees. I experienced these issues as an investor and joined the firm as a fiduciary financial advisor to teach other investors how to avoid these financial mistakes and build their wealth.
Investors, and the financial industry, love to focus on gross investment returns. But the hoopla around returns can disguise the truth: the actual return realized by an investor is net of both fees and any taxes created in generating those returns.
Each investor has a unique tax consequence, a bill incurred through their yearly income tax returns – often months after the investment transaction occurred. The delay in time between the transaction and the tax bill, not to mention the individual specificity of taxes, creates a disconnect between investment performance and the associated tax costs.
Investments generate taxes in three core areas: within investment funds, during investment transactions, and through the type of investment account.
When reviewing the investment costs, an attuned investor will recognize the mutual fund or exchange-traded fund's (ETFs) expense ratio as the price paid to generate the fund’s investment returns. Therefore, a higher expense ratio will have a more significant drag on returns. The expense ratio or cost of operating the fund is taken directly from the returns, and investors often see return values and charts net of these expenses. An investor looking to lower their investing costs will utilize vehicles, such as index investments, with low expense ratios. However, taxes, a less obvious and often overlooked cost, are omitted from the expense ratio.
One key indicator for understanding your mutual fund or ETF's potential tax cost is called "Turnover Rate." The turnover rate is the percentage of individual holdings within the fund that changed (were bought or sold) that year. Actively managed mutual funds and ETFs often have higher turnover rates due to the manager buying and selling holdings within the fund in an attempt to seek greater returns. Passively managed or index investment mutual funds and ETFs will typically have lower turnover rates, as fund managers only rebalance when the companies included in the index change (e.g., companies that enter and exit the S&P 500). As you may have guessed, the higher the turnover ratio, the greater the potential tax consequences. Thus, two mutual funds/ETFs with equal gross returns, equivalent expense ratios, and different turnover ratios may yield different after-tax returns.
Taxes strengthen the argument against actively managed funds. Actively managed funds are by name and nature, active. Thus, actively trading the positions within a mutual fund or ETF can result in a taxable event in the form of capital gains: short or long-term. If a fund manager sells a position within the fund within one year of purchase, the sale may result in the fund’s investors realizing a short-term capital gain on their income tax return. Short-term capital gains, and ordinary dividends, are taxed at federal ordinary income tax rates. Long-term capital gains occur at the time of sale when positions are held for longer than one year. Long-term taxable gains, and qualified dividends, are taxed at predefined federal tax rates (0%, 15%, or 20%) based on your income level1. Your place of residence will determine whether you are also liable for state and local capital gains taxes.
These taxable events are out of the individual investor’s control and can result in unanticipated consequences. For example, when other investors take money out of a fund in a down market, a fund manager may be forced to sell positions with gains to rebalance the fund2. Thus, the individual investor has the potential to see both losses in the value of their investments and a subsequent tax bill. Note this is a risk whether or not the mutual fund is active or passive but can be mitigated through the use of ETFs.
An even more frustrating situation comes as a result of timing. Any net realized gains must be distributed to the fund’s investors at least annually. While gains are typically distributed on a set schedule, a fund manager can decide to realize gains at any time3. Thus, an investor who purchases shares of the fund in advance of the next distribution date may receive a capital gain distribution despite having been an investor for only a short time. In this case, the investor will incur a tax bill for returns they did not fully receive. Investing and timing may be dance partners, but they are not always friends (and you know how that works out).
Alternatively, an individual investor can benefit from a new investment purchase, which recognizes gains of long-held securities in the form of long-term capital gains, despite having owned the investment for a short period.
The key takeaway? Trading activity inside a mutual fund or ETF creates potential tax consequences that flow through to your personal tax Form 1040, Schedule D.
The same tax rules that apply inside mutual funds and ETFs also apply to individual investors' purchase and sale of those investment vehicles. When an investor purchases a mutual fund or ETF, the taxation time clock begins.
If an investor sells an investment within one year of its purchase date, they may be subject to short-term capital gains. If the investor sells the investment after one year, they will potentially owe long-term capital gains. These gains will appear on the Form 1040, Schedule D of the investor’s federal income tax return4. Likewise, the investor’s residence place will determine whether they are liable for additional state and local capital gains taxes.
The type of account an investor uses for their investments will dictate how they will be taxed and may apply to specific investors in different ways. Retirement accounts, such as a Traditional IRA or a Traditional 401(k), allow investments to be made with pre-tax contributions and to grow tax-deferred. Thus, an investor avoids short and long-term capital gains that would otherwise be incurred if the same investments were held in a taxable brokerage account. Instead, the investor is only required to take Required Minimum Distributions (RMD) beginning the year they turn age 72, as ordinary income. When the investor eventually withdraws funds from a traditional retirement account, the withdrawals are taxed as ordinary income.
Alternatively, investors have the option of using a Roth IRA or Roth 401(k) account. Roth retirement accounts are funded with post-tax contributions. However, the investor's income and gains are tax-exempt, as are any eventual withdrawals from the account in retirement. Roth accounts can hedge against an increase in future marginal tax rates or a higher tax rate in retirement or provide account diversification for future income streams. Additionally, an investor can remove their contribution principal at any time, which provides the optionality for liquidity in a retirement account. However, gains may be subject to tax or penalty if withdrawn before retirement.
On the other hand, a standard brokerage account is taxable and will force the investor to pay taxes on any income and net realized gains each year, as described in the prior sections. An investor will only realize gains or losses on the investments at the time of sale. However, dividends and interest are taxed yearly as ordinary income even if the investor elects to reinvest them rather than receiving them in cash. Thus, ordinary and qualified dividends that otherwise would be sheltered in a retirement account are subject to taxation in a brokerage account.
A similar account type exists for educational expenses. A 529 account allows families to contribute money for use towards educational expenses into an investment account and have the investment earnings grow tax-free. The 529's preferential tax treatment is an opportunity for families to save for their children and grandchildren's education, or even themselves.
In practice, many investors have both taxable and tax-advantaged accounts. Thus, a critical component of tax management is deciding which index investments will go into each account. The pairing of investments to accounts is a critical step in ensuring that you maximize your investment strategy's after-tax performance. For example, a high dividend index investment fund, such as Vanguard’s Real Estate ETF (VNQ), has its dividends taxed as ordinary income. Thus, this type of index investment is best suited for a tax-deferred or tax-sheltered account. By contrast, an investment that generates most of its return through long-term price appreciation instead of current income might be a good candidate for a taxable brokerage account. This advantage is due to the potential difference between an investor's capital gain and marginal tax rates.
The key takeaway? Choose your investment account types wisely and match your investment fund characteristics to the appropriate accounts to minimize your taxes.
At One Day In July, we assist prospective clients in understanding the direct and indirect costs associated with their existing investments, including their advisor's cost, other fees and sales charges, and their potential exposure to investment-related taxes.
Our diversified index investment model uses ETFs to lower fees and minimize taxable events to the investor. Additionally, we work with clients to understand their present and future financial goals and build an investment solution designed to reduce the unnecessary tax burden.