From the November 2006 issue of Research Magazine • Subscribe!

Keeping Uncle Sam at Bay

While mainstream and casual investors alike remain largely oblivious to the negative impact taxes can inflict on the performance of an investment portfolio, savvy advisors know never to underestimate this factor. In fact, the emergence of exchange-traded funds has converted an entire generation of financial advisors to the (correct) belief that tax efficiency is an important component of portfolio management. ETF sponsors have been instrumental in educating advisors to the tax advantages of ETFs versus conventional actively managed mutual funds.

To illustrate, here's a few stunning statistics taken from Lipper's 2005 survey of taxes in the mutual fund industry:

o The 2005 estimated taxes paid by shareholders in taxable mutual funds increased 58 percent from 2004. In real money terms, that figure translates into $15.2 billion lost to taxes.

o Taxable investors in open-end mutual funds surrendered an average of 1.6 to 2.4 percentage points of performance a year over the 10 years ending Dec. 31, 2005 to taxes.

o Taxable equity and fixed-income funds gave up about 20 percent and 45 percent of their respective load-adjusted returns to taxes.

o In most instances, taxes on taxable fixed-income funds created a performance drag for the five-year period ending Dec. 31, 2005 of two to three times that of the funds' associated expenses.

After considering the numbers, is it any wonder why the investing masses consistently underperform key stock market indexes? Whether they realize it or not, taxes are killing them.

With a little planning, financial advisors can be ready to successfully tackle the tax issues of portfolio management. While having a CPA isn't a requirement, awareness of strategies that minimize the impact of taxes is essential. The end of 2006 is rapidly approaching, so there's no better time than now to revisit a few ideas that can make taxes less taxing.

1. Use the right financial products. The first step to minimizing the negative impact of taxes is to use tax-efficient investment vehicles. To that end, ETFs are famous for their low portfolio turnover and high overall tax efficiency. In fact, the entire menu of ETFs offered by Barclays Global Investors under the iShares umbrella reported zero capital gains distributions in 2005. Commenting on this feat, Lee Kranefuss, CEO of BGI's intermediary and ETF business, explains that "Few fund families can offer over 100 funds covering nearly every asset class, style and sector, along with tax efficiency due to the fund's low portfolio turnover and unique ETF structure."

While specific tax distributions vary with each fund company, a generally good track record of tax efficiency is evident throughout the entire ETF industry.

2. Understand that some ETFs are taxed differently. In taxable accounts, ETF returns are taxed as long-term gains if the fund was held for more than one year (at least a year and a day) before it was sold. If your tax bracket for ordinary income is 10 or 15 percent, the rate on this category of capital gain is equal to 5 percent, whereas capital gains are capped at 15 percent for ordinary tax brackets that are 25 percent or higher.

In contrast, ETFs that track commodity indexes or single commodities like gold and silver don't get any tax breaks. That's because the IRS views these assets as "collectibles" and therefore taxes their long-term gains at a maximum rate of 28 percent. Among ETFs in this group are the StreetTracks Gold Trust (GLD), iShares Comex Gold Trust (IAU), iShares Silver Trust (SLV), iShares GSCI Commodity Index Trust (GSG) and the PowerShares DB Commodity Index Tracking Fund (DBC). All short-term gains are taxed at ordinary income rates.

Likewise currency ETFs aren't as tax-efficient as their equity counterparts. Currency gains, losses and interest income are all taxed at ordinary income tax rates rather than at lower long-term capital gains rates.

3. Reduce short-term trading activity. "Tax laws currently favor long-term gains over dividend and interest income in two ways: capital gains face lower tax rates and incur tax only when realized," states David Swensen, author of Unconventional Success: A Fundamental Approach to Personal Investment.

Furthering Swensen's point, the cost differences between short-term and long-term capital gains are significant. For example, holding an ETF longer than a year can entail a maximum 5 or 15 percent capital gains tax liability, depending on the investor's tax bracket. On the other hand, short-term gains are taxed at ordinary income tax rates, which can result in substantially higher tax liabilities -- especially for high earners.

4. Distribute income wisely. What about investors with both tax-deferred and taxable accounts? Which should they draw income on from first? Conventional wisdom says to let the tax-deferred account grow as long as possible, but the correct answer may surprise you. In the spring of 2006, John J. Spitzer, Ph.D., and Sandeep Singh, Ph.D., CFA, two professors at the State University of New York, looked at withdrawal sequences using pairs of sub-accounts within a retirement portfolio. Using relatively standard allocations and average historic returns, they determined that by withdrawing the lower-returning asset first -- in this case, the bonds -- either portfolio lasted three years longer. In other words, the correct answer has more to do with expected investment returns and less to do with the advantages of tax-deferred accounts over their taxable counterparts. To quote the study's conclusion, "It is clearly better to first take distributions from assets that have a lower expected return rather than a higher one [and] the decision to withdraw first from the lower-rate-of-return asset is correct for any allocation of stocks and bonds, not only for the 50/50 allocation shown. Likewise, the decision holds for any marginal tax rate."

5. Coordinate tax gains and losses. Realized losses not only offer the chance to reduce taxable income but the opportunity to sell appreciated assets without incurring tax liabilities. Therefore, matching capital gains with capital losses is the smart thing to do. This is sometimes referred to as "tax loss harvesting." For portfolios with either large capital gains or losses, making sure both are realized in the same year can help reduce the stress of taxes.

Example: During 2006, a client has $30,000 of capital gain and no corresponding capital loss to offset the gain. That's bad news: Taxes on the entire gain of $30,000 are due. During 2007, the same client may have a $30,000 capital loss but no corresponding capital gain to offset it. More bad news: Losses can be carried forward, but deductions are limited to $3,000 per year. It may take years (or even a decade) before the full capital loss of $30,000 is realized. Instead, realize capital gains and losses during the same year to offset each other.

6. Work around the "wash-sale" rule. This point is closely related to the last one. The point here is to unload a portfolio's worst-performing security and to offset the loss with a capital gain. One extra step in this process is to redeploy the sale proceeds into an ETF with a similar investment objective or close correlation. A potential disadvantage of this strategy is that tax-loss selling can generate significant brokerage commissions or fund redemption charges if your client owns mutual funds. In addition, investors may unwittingly subject themselves to the IRS "wash-sale" rule, which disallows the re-purchase of "substantially identical securities" within a 30-day period. The good news is that ETFs can solve this complex problem.

Here's how a coordinated tax-loss sale would work with ETFs. Let's assume an investor wants to sell off an underperforming utility stock, but still wants to maintain portfolio exposure to the utility sector. Assuming this investor sells the losing security, the proceeds can be reinvested in an ETF tracking the same sector -- perhaps the Select Sector Utilities SPDR (Amex: XLU). This transaction can help this investor (your client) from a few different perspectives. As a tertiary benefit, the investor has reduced the risks of owning a single stock or bond by diversifying into an index ETF.

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Ron DeLegge is editor of www.etfguide.com; see www.etfguide.com or reach him at rond@etfguide.com.

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