Keeping Uncle Sam at Bay

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 [email protected].