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November 01, 2007 at 04:00 AM
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.
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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.
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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).
