Article by Eric Ervin
The month of April marks the U.S. tax filing deadline for individuals. For most, this can be confusing – if not dreadful – as taxpayers attempt to make sense of all the moving pieces in their financial lives, especially investments.
To add to the complexity, each security in a portfolio likely gets taxed differently, forcing a careful review of the year’s tax documents with a tax advisor. It is also increasingly important for investors to become familiar with tax terms like cost basis, ordinary income, and Schedule B.
In light of the intricacy of filing taxes, here are a few important takeaways investors should know going forward, especially when creating ETF and mutual fund portfolios.
The Difference Between ETFs And Mutual Funds: Capital Gains
Conventional wisdom says ETFs are more tax efficient than mutual funds, but what does that mean exactly? Both mutual funds and ETFs are baskets of different investments, which may change based on market conditions. But, mutual fund managers often buy or sell securities in an effort to outperform the market. If a mutual fund sells an underlying investment that has increased in value, it can result in a capital gain – a taxable event. Mutual funds are legally required to make these profitable distributions to investors, passing taxable capital gain payouts to investors, creating a tax liability for the mutual fund investor.
ETFs, on the other hand, are generally intended to track an underlying index/benchmark. To this end, ETF managers rarely buy and sell investments in their baskets. Therefore, ETF distributions are usually dividends from underlying investments, as opposed to a combination of both dividends and capital gain distributions. In recent years, the average capital gains distribution for small, large, and mid-cap funds surpassed 5% of a mutual funds’ net asset value, while ETFs are usually less than 1% on capital gain distributions.
Why is this important? Quite simply, taxes on dividends can be lower than taxes from capital gains payouts. If a mutual fund sells a profitable underlying investment that was held for less than one year, the capital gain payout is considered short-term, and taxed at ordinary income rates, which can be up to 39.6%.
Long-term capital gain rates may be less painful than short-term capital gains, but this rate is not guaranteed with holding mutual funds. If a mutual fund is held in a non-retirement account, one could potentially face an unanticipated tax expense, stemming from the fund’s capital gain payout.
Dividends, on the other hand, can be considered “qualified” if the U.S. stock or ETF was held for at least 60 days during the 121-day period surrounding the ex-date. Qualified dividends are taxed at a rate from 0% to 20% max, depending on one’s income bracket for that tax year. Comparatively, dividends can potentially allow investors to keep more of a portfolio’s generated income than other income-producing investments.
What About My Bond Interest?