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Are Your Investments Making Tax Season Miserable?

With this year's tax filing extension due date just behind us, tax season was an even more painful experience than usual for many mutual fund investors.  Many mutual fund companies have been distributing much higher capital gains to shareholders in recent years, resulting in higher related tax bills.  

The prolonged bull market in U.S. stocks, in combination with the ongoing migration from actively managed equity funds to passively managed ones, is driving this dynamic.  And if anything, these factors look likely to have intensified by the time 2017 is completely in the books.  Those of you with actively managed equity mutual funds in taxable or trust accounts are particularly exposed, but the good news is that these tax bills from passed-through capital gains can be avoided.

As clients know, we take great pains to ensure that investment portfolios are managed tax-efficiently.  One of the ways we accomplish this is to use exchange-traded funds (ETFs) as core holdings, and especially in taxable client accounts, rather than actively managed mutual funds.  Without getting into the gory details of what makes ETFs so tax-efficient, consider that the grandfather of the ETF world, the S&P 500 SPDR, hasn't burdened taxpayers with any capital gains since 1996.

What do actively managed mutual funds cost taxpayers over the long term?  In a study by Lipper, the mutual fund research company, the author estimated that taxable investors lost between 1.8 and 2.5 percentage points annually to federal taxes alone.  In fact, the study concluded that tax-inefficiency was a bigger drag on portfolio performance than either management expenses or sales loads.  In dollars and cents, 2.5 percentage points per year in tax drag will cut in half the final value after 30 years of a portfolio earning 10 percent before taxes.

It's an old saw but we believe in it: 

"It's not what you make, it's what you keep that matters."

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

Contact Paul