Account for High Tax Rates, Use ETFs for Efficiency

by on May 23, 2016 Categories: taxes, wealth management

Taxes are one of the most overlooked yet most critical factors in wealth creation. With changes to the tax code increasing the marginal tax rates on high income individuals, and the possibility these tax rates will increase further in the coming years, it is more important than ever to take every measure possible to eliminate unnecessary taxes in order to build wealth.

One solution is investing in exchange-traded funds (ETFs). Compared to mutual funds, ETFs offer tax efficiency because of their unique product structure. ETFs allow investors to avoid annual capital gains distributions and defer paying taxes on the capital gains until the shares are actually sold. This differs from mutual funds which distribute gains annually causing you to pay capital gains tax whether you sold your shares or not.

ETFs have two unique traits that allow for more favorable tax treatment. Unlike mutual funds, ETFs are traded on the secondary market just like a stock. When one investor sells their ETF shares to another investor on the exchange, the fund's underlying securities don't have to be sold in order to provide the seller with their cash form the sale. Additionally, ETFs redeem their shares through in-kind transactions that aren't considered a sale, and therefore, don't create a taxable transaction. The result of these ETF structural traits is greater tax efficiency and a substantial difference in the after-tax rate of return when compared to a mutual fund - even if the two funds are designed to replicate the same index.

You may be asking yourself why anyone would invest in a mutual fund when ETFs are so much more tax efficient. While there are some exceptions that may make a mutual fund more appropriate, the main reason is incentives. Mutual funds have imputed fees and expenses that lower returns for the investor, and a portion of these fees are used to compensate the advisor who recommended the mutual fund - it's essentially a kick-back or sales commission paid to the advisor. This system incentives a financial advisor to sell their clients suitable mutual funds that may not necessarily provide the best after-tax returns for their clients.