A couple of weeks ago, I was faced with what appeared to be a serious problem: my laptop wouldn’t run.
In a rush to prepare for a media event, I frantically called my self-proclaimed king computer geek who late on that ill-fated Sunday night, proceeded to race me through a complex list of possible causes. Just when it appeared my trusty Mac was headed for computer heaven, on a last ditch effort he somewhat reluctantly asked if the thing was plugged in.
Glancing at the power source, my face must have turned bright red; indeed, the cause of the problem was that one very obvious thing, leading me to once again realize that sometimes we’re in such a hurry that we can occasionally overlook a few simple things.
When it comes to investments and saving taxes, the “one obvious thing” I occasionally forget to check appears on page one of the 1040, lines 8a and 9a, otherwise known as taxable dividends and interest.
Turning to Schedule B, the culprit causing these taxable dividends and interest is often the result of investing in managed mutual funds. Often, but certainly not always, working people are not using these dividends and interest for income. On the contrary, the person is often investing these monies outside a tax deferred qualified plan (such as an IRA or 401k) and planning to let it sit there and (hopefully) grow for future use.
Although I’m a big fan of some managed mutual funds, when it comes to saving taxes, reducing fees and potentially increasing rates of return, this is the one area I usually first turn to the most.
Often, right there on Schedule B I’ll see a brokerage account and/or some mutual fund company(s) listed that are throwing these taxable dividends, capital gains and interest over to page one of the return. It’s at this point I will often give some information on what I call one of Wall Street’s greatest inventions, the illustrious “Exchange Traded Fund,” otherwise known as an ETF.
If you haven’t heard of an ETF, I would highly recommend learning a few things about them. Although it’s rare when I get excited about any investment product, when it comes to ETFs, I’m usually reaching for my seven year old’s pom-poms to help sing praise to them.
Please understand, an entire book can be written about ETFs but in the interest of this brief column, I’ll try to keep this real short and hopefully simple.
An ETF is a somewhat related cousin to that of a mutual fund, but there are a few big differences, perhaps best summarized by the simple chart below. Please keep in mind, these are general points and not necessarily true of every ETF. So, as with any investment, please don’t take these as exact; the points expressed should only be construed as examples. As with any investment, be sure to first understand the exact product before investing in any of them.
With that in mind, here goes:
|
MANAGED MUTUAL FUND |
ETF |
|
| Actively managed? |
Yes |
No. Most ETFs are passive investments comprised of an index such as the S&P 500 |
| Diversified? |
Typically, yes, within a stated market sector such as “large cap US stocks” or many other choices. |
Typically, yes, within a stated market sector such as “large cap US stocks” or many other choices.
|
| Can you buy or sell them during market hours? |
No. They are priced only at market close. |
Yes. Can buy or sell anytime during market hours. Trades like a stock. |
| Can you add a level of potential loss protection by strategies such as Stop Losses? |
No |
Yes |
| Who controls buying and selling the holdings within the fund? |
Fund manager in accordance to the prospectus and objectives. Investor has no control. |
Positions within the ETF are rarely traded. Investor controls buying and selling of the overall position.
|
| Average cost of holding the position? |
After sales loads and/or trading costs are applied, the national average to hold the position is generally between 1 and 2 percent annually, sometimes much more.
|
After trading costs are applied, the national average to hold the position is generally between .2 and .5 percent annually. |
| Historically, which structure provides better returns? |
It’s estimated that only 10% of fund managers beat the performance of the index they are benchmarking their performance to… |
…therefore, conversely, roughly 90% of index ETFs out-perform the fund managers trying to beat them. |
TAXES
When it comes to taxes, ETFs can be quite tax efficient. Given most ETFs are passively managed (the internal stocks within the position rarely get traded), ETFs typically distribute very little capital gains during the year.
In many cases, when I hear an investor complain about the amount of tax they are paying, my first question is “are you investing in managed mutual funds outside your retirement accounts,” and the answer is very often, “yes.” By looking at a tax return and carefully researching the positions within the person’s brokerage accounts, I can quickly provide a general assessment as to the tax ramifications the funds are causing.
If you aren’t familiar with ETFs, I would suggest checking out Yahoo Finance and/or ETFConnect.com. As to how you can research a mutual fund’s tax ramifications, above and beyond looking at a tax return, you may want to check out www.morningstar.com and a lesser known website that is one of my favorites, PersonalFund.com. Both of these offer various insights into a particular fund. When assessing tax ramifications, be sure to pay close attention to something called “Turnover.”
Turnover refers to the amount of times a fund manager sells holdings within the fund. Often, you’ll come across something called Turnover Ratio which is expressed as a percentage. A Turnover Ratio of 100% would mean the fund manager sells all holdings of the portfolio during the year and replaces them with something else. A Turnover Ratio of 50% would obviously mean half of the portfolio is replaced during the year, etc.. Needless to say, the higher the turnover ratio, the more likely it is that capital gain taxes are being passed off to you.
Of course, this isn’t to say a portfolio of managed mutual funds should be quickly replaced with ETFs. There are obviously a lot of considerations that need to be taken into account before anything is ever replaced, especially when tax considerations are involved.
But when it comes to trying to save a few dollars in taxes, likely pay less fees and increase performance, this is one way to potentially save a handful of taxes I personally wouldn’t want to miss.
Do you have any other “obvious” tax savings ideas? If you do, please, drop me a comment or email. I’d love to hear all about them.
