Whether you've written a check to the taxman or are waiting for a refund that's all too skimpy, you may well have a sour taste in your mouth after filing your 2015 tax return. How can you make next year's experience better?
By starting now rather than waiting until the end of the year or, even worse, procrastinating until next spring. With two-thirds of the year left, there's ample time to rejigger your finances to trim taxable income and maximize deductions. And your investment portfolio offers some key opportunities, especially if you've been paying tax on big year-end mutual fund distributions.
One option: Trade your actively managed funds for passively managed exchange-traded funds, or ETFs, which can help investors avoid annual taxes on earnings. In fact, to minimize tax risk, you might even favor ETFs over ordinary index-style mutual funds, which are already pretty efficient.
"ETFs do not issue capital gains distributions, and index funds almost never do," said Crystal Stranger, president of 1st Tax, a nationwide tax advisory firm for small business owners. "This essentially creates a deferral of taxes on capital gains that active funds would create."
The issue involves funds held in taxable accounts rather than tax-favored accounts, like IRAs and 401(k)s, which postpone taxes until funds are withdrawn. With taxable holdings, investors pay tax every year on payouts, such as interest, dividends and year-end distributions, even if this income is reinvested in more shares of the fund. For most investors, maximum tax on dividends and long-term capital gains (for assets the fund held for longer than a year) is 15 percent, while the rates for interest and short-term capital gains can be as high as 39.6 percent. Wealthy investors can pay even more.
Tax on interest and dividends is virtually unavoidable, but year-end distributions offer a lot of maneuvering room. These are net profits earned by the fund on holdings that were sold during the year, and they can be big if the fund has had a winning streak. Selling a winner happens when the fund manager thinks stock A's prospects have dimmed and stock B looks more promising.
In addition, the manager may be forced to sell simply to raise cash for investors who want to redeem or sell their shares. The realized gains from sales must be evenly apportioned to every share and paid out, resulting in distributions for everyone. In other words, those who sell shares can create distributions; tax bills are generated for those who do not.
"If a fund has to sell appreciated stocks to pay redemptions, it realizes capital gains that can ultimately be passed along to investors even if they did not sell their holdings," said John Correia, founder of Madison Asset Advisors in New York City.
Unfortunately, receiving the distribution, which usually comes in December, does not make you any richer than you were the day before, explained Nancy D. Butler, a certified financial planner and author of "Above All Else, Success in Life and Business." She notes that "although you may receive a large payout, you do not have an increased balance in your account, since the price per share will drop equal to the amount paid out." A $10-per-share fund that pays out $1 per share will become a $9-per-share fund.
You can assess the risk of receiving a big distribution by looking at the fund's "potential capital gains exposure," the percentage of share price attributed to capital gains that could be realized by sales. The higher the percentage, the greater the risk. Morningstar provides this figure under the Tax tab on its fund data page. Key the fund's ticker symbol into the quote space atop the home page.
One way to minimize this problem is to invest in index-style funds, which track standard market gauges, like the . Because index funds use a buy-and-hold strategy, they don't have as many sales to produce distributions. They can, however, be forced to realize gains if significant numbers of investors redeem shares.
This is where ETFs have an edge. Like index funds, most ETFs use a buy-and-hold indexing strategy that does not involve realizing gains on winners. But there's a difference: Once created, ETFs trade like stocks. So when an investor wants to pull out, he or she simply sells the shares to someone else, just as if they were selling her shares of Google or General Motors. The ETF managers therefore do not have to sell stocks owned by the ETF to raise cash. Hence, the redemption does not cause gains to be realized, so there is no distribution to tax. (The small number of actively managed ETFs do have taxable distributions.)
That doesn't mean there is never any tax. ETF gains are reflected in the share price — basically, the assets in the ETF fund divided by the number of shares. As the value of assets like stocks rises, the share price goes up. When the investor sells her ETF shares, she will be taxed on the capital gain, the difference between the sales price and original purchase price. But this tax can be postponed for decades, and the investor is blessedly free from annual tax in the meantime, leaving more money in the account to compound.
Distributions by actively managed funds vary considerably, of course, but can be big. John M. Scherer, founder of Trinity Financial Planning in Middleton, Wisconsin, offers the example of American Funds Growth Fund of America (AGTHX), a large capitalization growth fund. It paid a $3.391 per-share long-term capital gains distribution last December, equal to 8.24 percent of the $41.12 share price, according to Morningstar, the fund-tracking firm.
Over the past 10 years the Growth Fund of America has slightly trailed the S&P 500, which also holds large-company stocks. So why not invest in the S&P 500 instead? The SPDR S&P 500 ETF (SPY), which tracks that index, had no capital gains distributions last year. Nor the year before. Or the year before that.
For most investors, the tax efficiency offered by ordinary index mutual funds is good enough. The granddaddy of index mutual funds, Vanguard 500 Index fund (VFINX), which also tracks the S&P 500, also had no capital gains distributions last year.
But since index funds, as opposed to ETFs, can in theory have distributions caused by redemptions, most experts give ETFs the tax-efficiency edge. And ETFs have some other benefits. Because they require little management, their fees, expressed in the expense ratio, are all but nonexistent. SPY charges a mere 0.09 percent a year, compared to 0.16 percent for VFINX and 0.65 percent for the Growth Fund of America, a fairly typical charge for an actively managed stock fund. That difference adds up over the years.
Because they are traded like stocks, ETFs can be bought and sold anytime during the trading day, while mutual funds are bought or sold at the end-of-day price. That allows investors to move quickly when the market is making a dramatic change, and it permits limit orders, stop-loss orders and short sales — strategies generally not available with mutual funds, whether actively managed or indexed. Many ETFs have related options, allowing holders to do things they can't with mutual funds, like using "puts" to bet on a price decline.
Note, though, that buying or selling an ETF typically involves paying a broker's commission, just as you would with a stock, while mutual fund transactions done directly with the fund company are free. Even if you use a discount brokerage charging $5 a trade, commissions can be an issue if you buy or sell frequently, Butler cautioned.
If the ETF is in the same asset class as the fund you are leaving, their prices may move in tandem, so the ETF purchase can be done in one transaction, incurring just one commission, Butler said. But if you are changing from one class to another — from a conservative fund to a more aggressive ETF, for instance — the ideal time for selling the first fund may not be the ideal time for buying the ETF. So it might make sense to make the ETF purchase in stages, to minimize the risk of buying all the ETF shares when prices are high. That would raise the commission cost.
—By Jeff Brown, special to CNBC.com