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Cutting the Tax Man's Take

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If you’re looking for ways to boost your client’s investment performance, the key may reside in how well you use ETFs to reduce the bite of federal taxes.

According to Lipper, from 1996 to 2006, equity funds surrendered a startling 143 basis points of their average return to the IRS. By comparison, the tax efficiency of ETFs stems from the fact that accumulated capital gains can be shifted to institutional investors rather than individual investors. This is made possible through the share creation/redemption feature built into the ETF product structure. Creation units, usually built in 50,000-share increments, are redeemed by large institutions and reissued as individual stocks. During this process, the ETF portfolio manager can purge the fund of stocks with a low cost basis and thereby eliminate the overhanging tax liability of built-up capital gains. The end result is an ultra-tax-efficient investment.

Tax-Loss Harvesting Benefitso Realized losses can offset capital gains of winnerso Sale proceeds can be immediately reinvested in an ETF to maintain market exposure and keep the portfolio’s target asset allocation on track o Tax-loss sale of an individual stock or bond can avoid IRS “wash sale” rule by investing proceeds into a similarly oriented ETF.

One of the oldest ETF families, State Street Global’s Select Sector SPDRs, has never paid a capital gain distribution since its inception in 1998. Other ETF families such as the iShares, PowerShares, Rydex Investments and Vanguard have shown a similar record of low to modest annual capital gain distributions over the past several years.

ETFS THAT AREN’T “ETFS”Traditional ETFs typically use an open-ended fund or unit-investment-fund structure. Other products, particularly those tracking commodities and currencies, are using a grantor trust, partnership or exchange-traded note shell. The product structure you select will impact your client’s tax bill.

Products that use a partnership or limited liability shell are less tax-advantageous because shareholders pay taxes each year on the gains and income, even if they’re not distributed. Furthermore, commodity-linked products that use derivatives such as futures are subject to the IRS 60/40 rule, which mandates that 60 percent of gains or losses are considered long-term and the remaining 40 percent are taxed at higher short-term rates. The latter is obviously less favorable because short-term rates can equal a taxpayer’s ordinary income tax rates.

It’s also worth remembering that gold (GLD and IAU) and silver (SLV) exchange-traded products are taxed as collectibles, which means a maximum rate of 28 percent for long-term capital gains. Furthermore, gains and losses from currency-linked funds are taxed at income tax rates.

One way around the tax inefficiency of certain asset classes (aside from holding them in tax-deferred retirement accounts) is to consider exchange-traded notes (ETNs). “The value of ETNs is most advantageous in a taxable portfolio and in asset classes that pay ordinary income or short-term capital gains,” states Rick Ferri, CEO of Portfolio Solutions.

As good as that may sound, ETNs do carry an element of taxation uncertainty or risk. The IRS has not made an official ruling on how ETNs should be taxed. As things stand, ETNs are classified as prepaid contracts.

ETNs are not registered as mutual funds or ETFs, but are debt instruments. They pay a return linked to the performance of a single currency or commodity or an index of stocks, bonds and commodities. The iPath notes come with 30-year maturities and are senior unsecured debt issued by Barclays Bank.

WASH SALES AND MUNI BONDS For portfolios with both capital gains and losses, making sure both are realized in the same year can help reduce the stress of taxes. A problem that sometimes prevents investors from selling their losers is what to do with the sale proceeds. For example, a client may want to sell their shares in Dell Computer despite the fact they’re still bullish on the technology sector. To get around the IRS “wash sale” rule, an advisor can suggest simply redeploying the money into a technology ETF like the Sector SPDR (XLK), NYSE Arca Tech 100 (NXT) or the Vanguard Information Technology ETF (VGT).

Another strategy that skirts the issue is swapping corresponding ETFs. “I utilize ETFs as ‘placeholders’ in the portfolio, allowing me to harvest the loss by selling the original position and substituting a similarly oriented ETF,” states Jeff Janson, a planner at Grand Rapids, Mich.-based Financial Advisory Corp.

One new area in the ETF marketplace has been the introduction of municipal bond ETFs (see related story, p. 44). In September, Barclays Global Investors unveiled the S&P National Municipal Bond Fund (MUB) and State Street Global Investors launched the SPDR Lehman Municipal Bond ETF (TFI). Both funds are national in reach, meaning they include muni bonds from various states.

One of the big draws of municipal bonds is their tax-favored status. The interest income from munis is exempt from U.S. federal income taxes and the federal alternative minimum tax. Also, any portion of the income derived from muni bonds in your home state is treated as state tax-free.

Even though the interest paid on municipal bonds is tax-exempt, capital gains or losses from the sale of such bonds or bond funds still apply.

How will you know if your client is better off with municipal bonds versus taxable bonds? To find the answer, you need to compare the taxable equivalent yield (TEY) of municipal bonds to the yield of similar maturity and similar credit rating of taxable investments like CDs, corporate bonds, and U.S. Treasuries. TEY is the yield an investor would have to earn from a taxable security to equal the value of a tax-exempt security of the same credit quality.

Franklin Templeton has an excellent online calculator in the “Tools and Calculators” section of its website that compares the yields of taxable versus tax-free income investments. Simply type in your client’s state of residence, tax filing status (joint or single) and income range, and the calculator computes the TEY. From there, you can determine whether muni bonds fit the situation.

One piece of news that bears watching is a pending legal case before the U.S. Supreme Court that involves whether Kentucky can offer tax breaks on in-state municipal bonds while continuing to require its residents to pay taxes on out-of-state bonds.

In 2003, two Louisville residents, George and Catherine Davis, filed a class-action lawsuit against Kentucky because the state taxed their out-of-state bonds while exempting in-state municipal bonds. A trial judge ruled against them, but the Court of Appeals of Kentucky reversed the decision, arguing that the state law violated the Constitutional prohibition on states from discriminating against out-of-state commerce.

A final ruling is expected sometime during the fourth quarter and the results will be closely watched.

CONCLUSIONAccording to Lipper’s 2006 study of taxes in the mutual fund industry, taxable investors in open-end mutual funds over the 10 years ended December 31, 2006 surrendered 1.4 to 2.3 percentage points of performance annually because of taxes. In 2006 alone, Lipper conservatively estimates fund investors gave up $23.8 billion in avoidable taxes.

After considering these stunning figures, it’s not hard to see why so many investors are underperforming key stock market benchmarks. Taxes are confiscating their returns. Don’t let this happen to your clients.

Ron DeLegge is the San Diego-based editor of


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