Deborah L. Jacobs, Forbes Staff
Article from Forbes
This is guest post by Bill Harris, former CEO of PayPal and Intuit, and now CEO of the financial advisory firm Personal Capital.
As you gather various financial documents to prepare your tax return this year, take a look at your investments. Do you own any equity mutual funds? If so, you may be subject to avoidable tax hits. Not sure if your investments are costing you extra? Read on.
Beware Churning
Actively managed mutual funds tend to make a lot of trades during the year. While investment managers may try to maximize returns through frequent buying and selling, they may also be charging you for each transaction. That really adds up if the fund’s turnover rate is 100% or more. And if they’re buying and selling to the point of generating strong returns, they may also be creating taxable gains that you’ll have to pay for come April 17 (that’s when tax returns are due this year).
According to Morningstar, the ten most popular mutual funds by assets under management carried a 1.05% average annual tax cost over a five-year period.
Say you invested $100,000 over the past five years. Using a simple average of these funds’ 5-year annualized returns, your investment would have grown to $115,467 before tax. After taxes, however, your investment would be worth $106,203. That’s a difference of $9,263.
Low Turnover
Turnover is a very real threat. Let’s look at the top ten mutual funds by assets under management as reported by Morningstar. The average turnover rate is 74.4%. This means these particular mutual funds turn over approximately 74.4% of their holdings during the year.
To avoid excess transaction fees and lessen the burden of taxable distributions, some investors choose to buy index funds. Index funds track stock indices, such as the S&P 500, and therefore follow a more passive investment strategy. These can be good options, but they aren’t immune to distributions, especially when the target index replaces one stock with another. To mimic the target index, the index fund will also sell that stock, which could result in capital gains. Exchange traded funds (ETFs) pose a similar risk, but they generally carry lower fee structures, making them more attractive overall.
Tax-Managed?
Of course, some mutual funds are “tax-managed,” meaning the investment manager strategically decides which stocks to buy and which to hold based on capital gains and capital losses. The idea is to add balance and limit tax exposure. Of course, most mutual fund managers would likely sell winning stocks in order to take advantage of gains. Doing so means investment gains for shareholders, but also means greater distributions and potentially higher taxes, too.
Timing Is Everything
When did you buy your mutual fund? Please don’t say November or December. Yearend is the worst possible time to buy a mutual fund. That’s because, in most cases, mutual fund distributions are issued at the end of the year. Unless your mutual fund is an IRA or 401(k), you’ll pay taxes on those distributions. In other words, you’ll pay for a year’s worth of distributions made on a fund you’ve owned for a month or less.
If you buy a mutual fund for a taxable account, you may be paying more in taxes than you’d like. Each mutual fund prospectus has information about how much the average investor actually made after taxes. You’ll definitely want to do your homework before buying.
The ETF Option
Instead of buying a mutual fund, you may consider investing in ETFs. With ETFs, you have access to a professionally managed investment product without the excess taxes that accompany mutual funds.
The turnover ratio for ETFs also tends to be lower. For the top ten ETFs (as ranked by ETFdb), the turnover ratio is an average of 9.7%, according to Morningstar, compared with the average turnover rate of 74.4% for the top ten mutual funds. Where would you rather put your money?
DIY Tax Optimization
To avoid excess taxes at yearend, your best option is to forgo mutual funds and ETFs altogether in favor of a separately managed account. By purchasing individual securities, you can track and monitor investment performance and capital gains. Then you can decide which securities to buy and sell according to your own personal tax optimization strategy.
Managing your own investments for tax optimization may sound time consuming and complicated. For a long time, these types of personalized strategies were available only to the super rich who could afford a team of financial advisors to run the numbers. Not anymore. New technology and free online resources allow investors to easily track their investments regardless of their total net worth. You can now sign up for financial services online and easily build your own investment strategy.
Article from Forbes