ETFs in the Tax Crosshairs

ETFs in the Tax Crosshairs

A recently proposed tax on exchange-traded funds (ETFs) could be setting the stage for a major dust-up between lawmakers and money managers. Will it come to pass, and how would it impact your portfolio?

In mid-September, Senate Finance Committee Chairman Ron Wyden submitted a discussion draft for debate that includes a provision aiming to tax ETFs’ “in-kind redemptions,” which enable ETFs to swap stocks and bonds with other institutional investors in lieu of cashing out at the end of the day to balance their holdings. If adopted, this would alter the law that gives ETFs their tax advantage over mutual funds.

Needless to say, the proposal sent the fund industry into a tizzy.

Remember, ETFs are baskets of securities—mainly stocks and bonds—that can be traded throughout the day like stocks. ETFs are tax efficient because their shareholders control the taxes—an investor only pays capital gains taxes when they sell the ETF at a gain, and there (typically) aren’t any capital gains distributions.

There’s a lot of legislative sausage to be made before the new rule would come into effect, but if it does, ETFs would likely pay out capital gains distributions annually, like mutual funds do. That means ETF investors would be paying taxes on those distributions. But keep in mind that your cost basis also goes up in this case—meaning that when you sell, your realized gain is lower. So, all told, the rule won’t generate an overall tax increase for ETF investors, but simply change when some of the taxes are paid.

The Wyden plan would exempt ETFs in retirement accounts such as 401(k)s or IRAs.

For its part, Vanguard opted not to comment on the proposal itself, but told The Wall Street Journal that “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.”

But The WSJ also reported that Vanguard executives had, in recent years, discussed whether the hands-off tax treatment for ETFs would eventually be on the chopping block, even as they pushed ahead with building out their ETF suite. We suspect they aren’t the only fund provider that’s been anticipating this debate.

Is it time for ETF investors to panic? It’s way too soon for that. At the moment, the change is only a proposal, and you can bet the investment industry will have lobbyists out in droves to ensure it doesn’t come to pass. Still, even if the tax law changes, you probably don’t want to sell your ETF holdings if they’re at a gain just because they might cost a bit in capital gains each year.

We think the debate over the tax advantage of ETFs is a bit overblown in the media and investment industry, but it’s hard to deny that this change would radically alter the ETF narrative.

Vanguard Adds New Fund, ‘Innovates’ Target Retirement Lineup

Vanguard announced plans for a $666 billion merger on Sept. 28, combining the assets in the Institutional and Investor shares of its Target Retirement series of funds. The merger will be completed in February 2022. At the same time, it announced the launch of Target Retirement Income and Growth Trust, which provides a higher equity allocation for investors whose situation allows for more discretionary spending in their retirement years.

These changes will help retirement plan participants who use the Target funds and the new addition gives people an extra option once they hit the “end” of the Target Retirement glide path. But it’s a little much for Vanguard to be crowing about something it had the ability to deliver a long time ago.

Vanguard Chair Tim Buckley touted the merger as “innovative,” and the Vanguard PR machine says it will save investors $190 million in fees. Sounds like a lot, right? But when compared to the $666 billion in the combined funds, you end up with a measly 0.029% savings.

If Vanguard really wanted to be innovative, it could have saved investors money years ago by simply substituting the lower-cost share classes of the index funds that populate its Target Retirement funds-of-funds suite instead of the higher-cost shares used since the product’s launch in October 2003.

Let’s take a look at the Target Retirement 2030 fund as an example.

The Institutional shares are sold with a 0.09% expense ratio because they invest in lower-cost Institutional or Admiral share classes of other Vanguard funds. The Total Stock Market Index fund Institutional shares held in the Institutional version of the portfolio, for example, cost 0.03%.

The regular Investor shares of Target Retirement 2030 sport a 0.14% expense ratio, since many of the underlying funds are Investor class shares, which cost more. The Total Stock Market Index fund Investor shares that the “investor” version of Target Retirement 2030 fund holds cost 0.14%.

Today, the two 2030 funds hold about $59 billion (Institutional shares) and $39 billion (Investor shares) in total assets. Something tells us the Investor shares would have qualified for the lower-cost underlying funds years ago.

So why now? Simple. Vanguard is likely having trouble lowering costs further; now it’s apparently “innovating” by merging funds. That only takes it so far.

In a future update, we’ll look closer at the challenges Vanguard is facing in cutting fees and why expense ratios can’t be dropped as easily anymore. Stay tuned.

Saving Social Security From Insolvency

It’s not unreasonable for anyone paying attention to their retirement savings and the state of Washington politics to ask: Is Social Security built to last?

Manager of Financial Planning Andrew Busa had this to say:

As part of its annual report on the financial health of Social Security and Medicare, the Social Security Board of Trustees said last week that Social Security would be insolvent one year sooner than previously projected. The increased shortfall—which was less than many analysts had expected—occurred because payroll taxes took a hit when businesses shut down during the COVID-19 crisis.

This means that—without government intervention—retirees could experience a cut of about 24% to their Social Security benefits beginning in 2033. Do we think this will come to pass? Not likely.

The first thing to know is that Congress has a means to solve this problem…but it’s a political hot potato. Why? To get Social Security back on track, Congress needs to make the unpopular decision to raise Social Security taxes. If you’re seeking reelection, you probably don’t want to raise your hand for that sort of proposal. It’s easier to kick the can down the road to the next person.

At the same time, if you’re trying to get reelected, you also don’t want to cut the benefits your voters are counting on.

That makes the timing of any congressional action difficult to predict, but we expect lawmakers will step up and keep benefits cuts off the table by acting before the clock runs out in 2033.

Having said that, what actions, if any, should you be taking? In most cases, we suggest sticking to your current financial plan.

We caution against taking Social Security benefits early, and encourage most of our clients to wait to file until at least their full retirement age (FRA) to draw the maximum benefit. Every year you delay taking benefits beyond FRA until age 70 results in an 8% per year increase over the base FRA amount in benefits, so for those who can afford to wait, it makes sense.

Podcast: Are Crackdowns Fracturing the Chinese Economy?

The Chinese government is trying to whip its corporations into shape—and markets around the world are feeling the sting. In this episode of The Adviser You Can Talk To Podcast, Research Analyst Liz Laprade and Chief Investment Officer Jim Lowell join Director of Research Jeff DeMaso to discuss the rapid changes in the Chinese economic landscape, and what they portend for global markets. They touch on:

• Which sectors are affected
• What’s motivating the government crackdown
• Why what happens in China doesn’t necessarily stay in China

Please click here to listen!

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 our most recent Market Takeaways, Vice President Steve Johnson gave his take on “buying the dip,” while Research Analyst Liz Laprade discussed the recent spike in bond yields.

We hope you find these commentaries engaging and accessible. If there are any topics you’d like us to address, please send an email to info@adviserinvestments.com!

About Adviser Investments

Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trusts, institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFs, socially responsible investments and tactical asset allocation strategies, with particular expertise in Fidelity and Vanguard mutual funds. We take pride in being The Adviser You Can Talk To.

Our minimum account size is $350,000.  To see a full list of our awards and recognitions, click here, and for more information, please visit www.adviserinvestments.com or call 800-492-6868.