In This Issue:
Are ETFs More Tax-Efficient? Not at Vanguard
In April, we parsed every Vanguard and Fidelity fund and exchange-traded fund (ETF) to highlight the most (and least) tax-efficient among them. This week, we look at how ETFs and funds differ in how their tax status impacts your portfolio’s bottom line.
Conventional wisdom points to exchange-traded funds as the clear winner in terms of tax burden—however, the data doesn’t back that up when it comes to Vanguard. In fact, the fund giant’s ETFs have essentially no tax advantage over its Admiral-class index offerings.
Yes, in the past, after-tax returns on Vanguard’s ETFs edged out their open-end counterparts’ returns by a few basis points. But that advantage only pertained to higher-cost Investor share classes.
Regular readers will recall that in November 2018, Vanguard reduced the required minimum investment for its Admiral share class (and its lower fees compared to the Investor share class) to $3,000 from $10,000 on 38 index funds. Later, it closed the index funds’ Investor shares to most investors and broadened access to Admiral shares. The widespread availability of Admiral shares narrowed the tax differences to within a basis point or two—sometimes in the favor of the traditional open-end fund.
How Do ETF Taxes Work?
So why are ETFs generally considered to be more tax-efficient than mutual funds? It comes down to how funds return your money when you cash out.
When you sell shares of a mutual fund, you expect cash in return—and to get that, the fund managers need to sell a stock or a bond. When that asset is sold at a gain, it triggers a tax bill for the fund, thereby reducing its after-tax returns.
The sale of an ETF share isn’t necessarily trading with the “fund” itself. Rather, you’re trading with another investor on an exchange (like trading a stock). The ETF’s managers have no idea the trade is even happening, and it creates no taxable event for the fund.
ETFs also have an edge when it comes to large institutions, aka “authorized participants,” redeeming shares of the ETF at volume in one transaction. Instead of giving the institution cash for the shares, fund companies swap some of the stocks or bonds in the portfolio—what’s known as an “in-kind” transfer. Then, the onus falls on the institution to turn the stocks or bonds into cash.
There’s no tax penalty to the ETF for “in-kind” transfers; plus, the fund can select the shares it wants to weed out, and of course, they’ll pick those with the lowest cost basis, which have the highest potential tax impact on the ETF.
That’s why ETFs have a tax advantage over mutual funds…with some notable exceptions.
Vanguard’s index mutual funds enjoy an upside over those of other companies. Since Vanguard’s ETFs and open-end index funds are share classes of the same fund, the open-end index funds come with the same tax advantages as the ETFs, accounting for the minuscule differences between after-tax returns.
From where we sit, the only reason to invest in a Vanguard ETF over its open-end Admiral peer is if you’re looking to trade throughout the day—something ETFs offer that mutual funds don’t. (However, if you’re going to trade ETFs frequently, there’s extra complexity involved, and after-tax returns probably aren’t a primary concern for you.)
With Vanguard’s move to allow essentially every investor to become an “Admiral,” the company has eliminated the after-tax advantage its ETFs once had over their open-end siblings. If someone tells you that a Vanguard ETF is somehow better than an Admiral-class index fund, you know better—it isn’t, and kudos to Vanguard for making it so.
What About Factor-Fund Taxes?
Vanguard’s Factor ETFs are relatively new—as is their single open-end factor fund, U.S. Multifactor—with little more than three years on the books. So far, as a group, the funds’ tax efficiency is keeping in line with the rest of their ETF peers. More notably, they’ve achieved much better efficiency than other offerings from Vanguard’s quantitative investments team, like Global Minimum Volatility, Strategic Equity and Strategic SmallCap Equity.
The two “strategic” quant funds have posted tax efficiency running in the high-80% to low-90% range, but they’ve also gone through periods where it’s been lower. Global Minimum Volatility’s efficiency is in the 80s.
We want to see more from the factor funds to know how they really perform, but consider that in the first three years, only one, U.S. Momentum Factor ETF, outperformed Total Stock Market ETF or S&P 500 ETF—and that’s both before and after taxes. The other factor ETFs lagged by 0.4% to 0.5% on an annual basis. That adds up.
For more on tax-efficient investing, please read our exclusive special report, Investing and Taxes: Maximizing Gains While Minimizing Taxes. Click now for your complimentary copy!
Planning for a Capital Gains Tax Increase
What does the Biden tax plan mean for investors? To discuss where things stand right now, we turned to one of Adviser Investments’ tax specialists, Vice President of Wealth Services Patrick Carlson, who had this to say:
The first thing to remember is that all the tax hikes you’ve been hearing about—except those already passed in the American Rescue Plan—need to be approved by Congress. That means any tax code updates may look very different by the time they are fully baked and written into law.
That said, President Biden’s proposed American Families Plan would raise $1.5 trillion over a decade by taxing high earners. For instance, the top individual federal income tax bracket would revert back to the pre-Trump rate of 39.6% (from the current 37%) for individuals earning more than $400,000 a year.
The ceiling on long-term capital gains would rise even more, from 20% to 39.6% for the wealthiest Americans. That bump, which essentially taxes capital gains like ordinary income, would apply to individuals reporting over $1 million in W-2 income, plus gains from selling stocks, bonds and other assets held in taxable accounts.
If that change is enacted—and at present it’s still in question—there would be instances where we would suggest avoiding taking some of the largest capital gains. We’ll keep you apprised.
Another change under discussion—the possible elimination of the “basis step-up rule”—would alter the way capital gains taxes are paid on estates when people pass away. Under current law, upon inheriting an asset, the basis of that asset readjusts to the typically higher date-of-death value. This minimizes what the beneficiary would pay in capital gains tax if they were to sell the asset upon inheritance. The American Families plan could revise that concept. Upon death and transfer of taxable assets, basis adjustment would no longer be available. Instead, the proposal grants exclusions: $1 million to individuals and $2.5 million to married couples.
The administration has also floated the notion of raising estate taxes in other ways. An individual today can leave up to $11.7 million to heirs, including lifetime gifts, before the 40% estate tax kicks in. While the rumored change would lower that exemption significantly, the proposal to change estate taxes faces major opposition, and more recent scuttlebutt indicates that this idea has been set aside for the time being.
The last potential tax hike to mention is viewed as the cornerstone of the plan: The corporate tax rate, which would increase from 21% to 28%. While that wouldn’t impact individual or estate taxes, higher corporate taxes can eat into corporate profits and weigh on economic growth.
If that’s the case, you’d think higher corporate taxes would depress stock prices. Yet, that’s not proven true historically. In fact, going back to 1945, the S&P 500 has averaged a 10% gain during years in which the U.S. corporate tax rate was below 35%—compare that to the average annual 10.3% gain when the tax rate was 50% or higher.
The bottom line is that tax hikes haven’t correlated with poor performance from stocks. Before you make any changes in your financial plan, keep in mind that while death and taxes are certain, the proposed tax hikes are far from assured—many won’t happen in this tax year and details are changing by the day.
Podcast: Biden Tax Hikes—What We Know Now
In this episode, some of Adviser Investments’ wealth management experts tell us more about the Biden administration’s proposed tax hikes, including how the changes may impact:
- Income taxes
- Capital gains taxes and adjusted basis calculations
- Estate and gift taxes
Most importantly, the team offers some thoughts about how strategic financial planning may help lessen the sting if these tax hikes come to pass.
Click here to listen now!
Adviser Investments’ Today’s Market Takeaways
There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.
In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets. This week, Research Analyst Liz Laprade discussed Biogen’s landmark new Alzheimer’s drug and the potential ripple effects for the health care sector, while Vice President Steve Johnson looked at the continued speculative fervor on Wall Street.
We hope you find these episodes engaging and accessible, and please let us know if there are any topics you’d like to hear us address by sending an email to firstname.lastname@example.org!
About Adviser Investments
Adviser Investments operates as an independent, professional wealth management firm with expertise in Fidelity and Vanguard funds, actively managed mutual funds, ETFs, fixed-income investing, tactical strategies and financial planning. Our investment professionals focus on helping individual investors, trusts, foundations and institutions meet their investment goals. Our minimum account size is $350,000. For the eighth consecutive year, Adviser Investments was named to Barron’s list of “America’s Best Independent Advisors” and its list of the top advisory firms in Massachusetts in 2020. We have also been recognized on the Financial Times 300 Top Registered Investment Advisers list in 2014, 2015, 2016, 2018 and 2019.
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The Barron’s America’s Best Independent Advisers rankings consider factors such as assets under management, revenue produced for the firm, and quality of practice as determined by Barron’s editors. According to Barron’s, “around 4,000” advisory firms were considered for this recognition in 2020; with about 1,200 firms receiving recognition. The award sponsor has not disclosed how many firms were surveyed or considered for this recognition, nor the percentage of total participants that ultimately received recognition. For more information and a complete list of recipients visit https://www.barrons.com/report/top-financial-advisors/1000/2020. Years Received: 2020, 2019, 2018, 2017, 2016, 2015 & 2014.
The Barron’s Top Advisor Rankings by State (Massachusetts) (also referred to as Barron’s Top 1,200 Financial Advisers) considers factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work. According to Barron’s, “around 4,000” advisory firms were considered for this award in 2020, with about 1,200 firms receiving recognition. For more information and a complete list of recipients visit https://www.barrons.com/report/top-financial-advisors/1000/2020?mod=article_inline. Years Received: 2020, 2019, 2018, 2017, 2016, 2015 & 2014.
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