Investors seek income tax efficiency in various ways. One method involves prioritizing contributions to tax-advantaged accounts.
Investment in tax-efficient funds may also help, with index funds often offering tax advantages and ETFs providing the possibility of lower turnover costs.
Morningstar recommends several core international-stock index funds that boast excellent tax-efficiency ratios; additionally, many balanced funds (stocks and bonds) also boast impressive tax efficiency numbers.
1. Low Turnover Ratio
Traditional index funds and ETFs tend to have lower turnover ratios than actively managed funds due to not needing to buy and sell as often for returns comparable to active managers’ strategies. Conversely, inverse and leveraged ETFs often have higher turnover because their strategies rely heavily on derivatives – these strategies could cause large capital gains distributions as part of their investment objective.
Low turnover ratios typically imply fewer taxable events for investors to report and, thus, avoid incurring higher capital gains taxes. Furthermore, some tax-efficient index funds use other strategies to minimize tax events like tax loss harvesting to minimize this liability.
Investors with both tax-advantaged (retirement) and taxable accounts should strive to allocate the most tax-efficient assets into their retirement account first, before gradually switching over to less tax-efficient investments in their taxable account as necessary. For example, one may hold stock index funds in their retirement account while investing in tax-efficient bonds like municipal bond funds in their taxable account.
2. Low Taxes on Short-Term Gains
Taxable investors face a constant battle to reduce their tax bills. While people can certainly take steps to mitigate their taxes by allocating the most growth-oriented investments to tax-efficient accounts, achieving optimal placement of all asset classes within their taxable portion requires thoughtfulness and consideration.
Many traditional index funds have low turnover and therefore are generally tax-efficient, but even some of Morningstar’s Top Picks for US Core Equity could result in substantial capital gains distributions in certain years.
Capital gains taxes can be minimized through several strategies employed by these funds to keep capital gains taxes at a manageable level, including limiting sales of existing holdings and harvesting losses that have decreased in value in order to offset future gains. Investors can further lower their tax bills by contributing their capital gains donations through donor-advised funds; doing so enables them to take both itemized deductions as well as the standard deduction, providing flexibility during tax filing season.
3. Ease of Rebalancing
As investors rebalance their portfolios to align with their goals and risk tolerance, they must carefully consider both trading costs and tax implications. Rebalancing may trigger capital gains distributions that trigger tax liabilities as well as transaction fees such as commissions or bid-ask spreads.
Index funds tend to trade less frequently than actively managed funds and don’t make distributions, making them more tax-efficient in the long run. This can reduce your tax bill while helping keep you invested for years.
When searching for tax-efficient stock funds, look for those with low turnover and capital gain percentage, particularly among foreign stocks. International bond funds may also reduce your overall tax burden by providing access to investment income that’s often exempt from federal and state taxes – possibly even triple tax exempt at local levels! All of these advantages make tax-efficient index funds ideal investments for any taxable account.
4. Flexibility
Investing in tax-efficient index funds allows for greater control over how to distribute your money between taxable and tax-advantaged accounts. Just keep in mind that a portfolio made up solely of tax-efficient funds may be too risky.
Keeping some assets in taxable accounts could be advantageous to your long-term investment plan, enabling you to use them towards retirement or other goals with lower tax rates.
Passive index funds tend to be more tax efficient than active mutual funds due to their focus on limiting taxable capital gains, with low turnover and no distributions of gains to investors. Exchange-traded notes (ETNs), another subset of ETFs that specialize in tax efficiency, offer even further savings; these products are debt securities issued by an issuing bank tied directly to an index’s performance and therefore subject to short-term capital gains taxes when sold – yet do not distribute dividends or reinvest them as with conventional ETF shares do.