This article appeared in the May 2019 edition of Nevillewood Living.
Most of us are comfortable paying taxes on the amount we earn, as well as on the gain of a profitable investment. Seems a fair price tag for the privilege of living in a country where freedom is cherished, and personal and professional opportunities are limitless.
Paying taxes when you have lost money, however, may feel a bit like having a tooth extracted without pain medication. Quite a few investors have felt this pain this tax season, as they have owed taxes on 2018 capital gains while their portfolio declined in value.
How does this happen? And how can you prevent it from happening to you (perhaps again, maybe this wasn’t the first time?)
A couple years ago, we wrote about Exchange Traded Funds (ETFs), comparing and contrasting them to traditional open end mutual funds. You may recall, an open end mutual fund that generates capital gains from portfolio trading activity is required to distribute those gains to shareholders of the fund on an annual basis. So, in a year like 2018 when the market was down, a mutual fund may sell a long term holding for a gain. Even though the overall portfolio may be down for the year, this sale will generate a capital gain on which you, a shareholder in the fund, will need to pay taxes.
One very large mutual fund company (a household name) paid out substantial capital gains last year to its shareholders, even though its stock portfolios lost money for the year. You can imagine the surprise of the funds’ shareholders. Many were probably asking Where’s the Novocain?
You may recall, ETFs are similar to traditional mutual funds in that they offer a cost effective way to own a diversified portfolio or a particular sub class of the market. Along with lower costs, intraday trading capabilities, and more precise allocations, however, ETFs also offer the benefit of incredible tax efficiency.
The exchange traded feature of ETFs (along with the fact that many are passive vehicles) means that a stock ETF does not trade its portfolio in a way that generates capital gains. As a shareholder in the ETF, your gains remain unrealized via the appreciating price of the ETF, while trading in a traditional mutual fund generates gains that are realized and thus generate a tax liability.
Of course, if you want to convert those unrealized ETF gains to cash, you will need to sell ETF shares and this will generate a taxable realized gain. However, the crucial difference here is that you will be more in control of when this gain is realized, vs with a traditional mutual fund where you relinquish that tax planning control to the fund manager.
Consider using ETFs in your portfolio because of the several advantages they offer over traditional mutual funds. For many, 2018 was a stark reminder in particular of the potential tax advantages of using ETFs within your portfolio.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.