While investors typically focus on the potential for high fees to hamper long-term returns, they can overlook the erosive effect of taxes on portfolio values. American Century Investments has published research exploring the potential to reduce or defer taxes by harvesting tax losses, managing capital gains and dividends, and strategically planning investments. ETFs offer the potential for improved tax efficiency as compared to other vehicles. Sandra Testani, CFA, CAIA, Head of ETF Product and Strategy, and Rene Casis, Vice President and Head of Portfolio Solutions, will delve into the benefits of year-round tax strategies that can help clients save on taxes, grow their portfolios, reduce costs and manage risks on an upcoming webcast.
In tax loss harvesting, investors sell investments at a loss to offset taxable gains. If realized investment losses exceed taxable gains, investors can reduce their taxable income by up to $3,000 per year for a married couple or $1,500 per year for a single taxpayer. Tax losses not used in the current year can be rolled over to reduce taxable gains or ordinary income in future years.
When managing capital gains, investors are advised to understand that higher tax rates are charged on investments sold within 12 months, while lower tax rates are charged on investments sold after a holding period exceeding 12 months. Qualified dividends, such as dividends on corporate stocks, are taxed at lower long-term capital gains tax rates. In contrast, nonqualified dividends, such as those paid by REITs or taxable bonds, are taxed at the same rates as ordinary income. Understanding when mutual funds pay capital gains and dividends, often in December, can also be part of a tax planning strategy.
Mutual funds often have higher portfolio turnover, and potentially higher taxes, than are experienced by exchange-traded funds (ETFs). The main contributor to this result is that mutual fund activity is cash-based. Mutual fund redemptions cause the sale of portfolio securities, which can trigger either short-term or long-term capital gains or losses for all shareholders in the fund. When ETF shares are sold, they are purchased by other investors, which does not trigger a taxable event. Investors holding ETF shares for many years may be able to defer capital gains tax liabilities until their shares are sold.
Beyond the low turnover of investment holdings by ETFs, another contributor to tax efficiency is their structure. Investments into and out of ETFs are accomplished through an in-kind creation and redemption process. When ETF shares are redeemed, a trade desk delivers shares of the ETF in exchange for shares of the underlying stocks. By this exchange mechanism, the ETF does not create a taxable event when ETF shares are redeemed. Historically, fewer than 10% of equity ETFs have distributed capital gains, while more than 50% of equity mutual funds have taxable distributions.
Resources:
Three Tips To Help Temper Taxes
Understanding the Tax Efficiency of ETFs
WEBCAST – Investing with an Eye on Taxes with ETFs
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments’ portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
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