Question: I own a number of mutual funds. Should I be switching my investment assets to ETFs for income tax savings?
Answer: Mutual funds and ETFs (exchange traded funds) are common investments for personal portfolios. ETFs are generally considered more tax efficient than mutual funds. However, you need to consider what type of assets are being invested to determine whether mutual funds or ETFs are appropriate in each circumstance.
Mutual funds are one of the most common types of investments for individual investors. Mutual funds are designed to invest in a variety of securities ranging from stocks, bonds, commodities, and other types of investments. Some mutual funds are specific in nature to a particular type of investment (e.g. large growth oriented stocks or long-term bonds) while others are more general in nature. Money market funds which primarily invest in government notes and bonds and certificates of deposit are another type of mutual fund. Falling into a category of regulated investment companies, mutual funds are generally not subject to Federal income tax provided they annually distribute substantially all of their earnings including interest, dividends and capital gains to the mutual fund investors.
Mutual fund income is reported by the owners so that the income earned by the mutual fund has the same character of income reported by and taxed to the investors. Distributions of interest income earned by a mutual fund will be reported as interest by the investor. The same holds true for dividends, capital gains and other types of earnings distributed by mutual funds. Some mutual funds are more tax efficient than others. A mutual fund which primarily invests in securities that generate a large amount of income which is taxable at the highest marginal Federal income tax rate will be less tax efficient than a fund which primarily invests in growth-oriented stocks which produce little in the way of highly taxed earnings. Similarly, a mutual fund which does not purchase and sell securities on a frequent basis is likely to be more tax efficient than one that routinely sells appreciated positions and generates capital gain income.
ETFs are similar to mutual funds in that they hold a portfolio of investments for their investors. Like mutual funds, ETF investors are taxed on fund distributions of interest, dividends, capital gains and other types of income. The major tax difference between mutual funds and ETFs is is that ETFs typically generate fewer capital gains which are taxable to investors. Among other technical reasons for the reduced capital gain tax burden, many ETFs are index based meaning they are designed to track a market index such as the Standard and Poor’s 500 index. ETFs, as a result, tend to constitute more passively managed portfolios with lesser turnover of investments than mutual funds which are actively managed and engage in more frequent purchases and sales of portfolio securities.
While ETFs are generally more efficient from a tax perspective, an investor should consider which assets are being invested before focusing on tax efficiency. Clearly if the investment is made with assets held in an investor’s name individually, the tax efficiency makes ETFs a better tax-wise investment choice as the ETF investor will not be recognizing as much income as a mutual fund investor. However, if the investment is made with assets held in a 401(k) plan, profit sharing plan, an IRA or some other tax deferred vehicle, the tax efficiency is far less meaningful as income from these accounts is tax deferred and tax will not be due and payable until distributions are made from the investor’s tax deferred account. As with mutual fund investments, a tax liability may arise upon the sale of ETF shares.
As a prospective investor, you should recognize that the most important consideration for any investment is not tax efficiency but the quality of the investment itself. Historical investment performance, projected future performance, managerial expertise of the fund managers, investment and administrative charges and a multitude of other factors should be the primary determinants of whether and where to invest. Only after considering the available alternatives should income taxes be considered.
The Tax Corner addresses various tax, estate, asset protection, and other business matters. Should you have any questions regarding the subject matter or if you have questions, you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfbbg.com.
