Why Pay More Income Tax Than You Have To?
If you are not a member of Congress, you are not a “lawmaker.” While you do not make laws, you retain some control over what you do to take advantage of the laws for your own benefit. For instance: WHY PAY MORE INCOME TAX THAN YOU HAVE TO?
Today, I would like to focus on Line 8. on your federal income tax return. This is the line where you write in the capital gains from investment. Many people I talk to got a nasty surprise when they looked at their 1099 this year and saw a big number under capital gains despite not seeing their account grow much in value last year. When you sell an investment, you either have a gain or a loss. If your gains are greater than your losses, you report the figure on Line 8. as a capital gain. Most people these days use mutual funds for their stock investments and that creates a potential new problem. Mutual fund managers typically have many internal sales through the calendar year and they are required to net the gains and losses. If they have a net gain, they have to pay that out to their shareholders in the form of a capital gain. These are typically paid out, without much warning in December each year. What is particularly painful about these taxable gains is that you may not have made any money, yet could be stuck paying the tax. Mutual Fund Capital Gain Distributions Explained
How that could work:
First you need to understand that a stock mutual fund may own one hundred or more unique companies and that they may have bought their shares years ago at much lower prices than when you bought into the mutual fund. For instance, if like many mutual funds, they didn’t do much last year, but they sold some of their position in Apple stock. They could have purchased Apple years ago at $20/share and sold it at $100 giving the fund a massive gain for which they will have to pay out to shareholders if when they net all the gains and losses from sales throughout the year there is a gain (no tax owed for non-IRA or 401k accounts) . In this example, assuming you bought into the mutual fund last year, you never experienced the benefit of Apple’s stock soaring in value, but get stuck paying the tax.
ETF’s to the rescue.
Exchange Traded Funds (ETF’s) are a very tax-efficient alternative for taxable accounts.
Why? For starters, because they’re index (mirror their benchmark such as S&P500) funds, most ETFs have very little turnover (sales), and thus amass far fewer capital gains than an actively managed mutual fund would. But they’re also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.
When a mutual fund investor asks for their money back, the mutual fund sells securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor (this is done internally, not directly by investor) like a stock. No muss, no fuss, no capital gains transaction for the ETF.
ETF’s use an “in-kind” transfer rule to almost trade shares rather than sell them which gets them around having to have a sale and potential gain each time they want out of a holding. Click on this link to see how that works as it’s a little complicated.
Bottom line is that when mutual funds are leaving investors in taxable accounts with large payouts and tax bills, ETF’s are given special tax advantages that investors should take a serious look at. One other potential advantage for ETF’s is that most come with very low internal expenses because they do not have a management team.