Investing is about more than just maximizing returns. It’s also about minimizing costs and optimizing tax efficiency.
Two popular investment vehicles that offer tax efficiency are index funds and exchange-traded funds (ETFs). These investments have gained immense popularity due to their ability to deliver market returns with low fees and tax benefits. While you may be aware of the low management fees charged by these investments, don’t ignore another significant benefit: Their tax-efficiency.
Here’s why tax efficiency should be important to you.
What is tax efficiency?
Tax efficiency refers to the structure of an investment that permits it to minimize the tax impact on your returns. It’s about having an investment portfolio that reduces tax liability while achieving your financial goals.
Tax efficiency is achieved through strategies that lower the amount of taxes paid on investment gains, like capital gains and dividends, which can significantly erode your returns over time.
Passive vs. active management
One of the critical reasons index funds and ETFs are considered tax-efficient is their investment strategy. Both replicate the performance of a market index, like the S&P 500, rather than actively selecting individual stocks to “beat the market.”
Index funds and ETFs are tax efficient
Portfolio turnover refers to how frequently a mutual fund buys and sells stocks within the portfolio. A high turnover rate can lead to capital gains distributions, which are taxable events.
Index funds and ETFs often have lower turnover because they only make changes when the underlying index they’re tracking changes. This results in fewer capital gains distributions, thereby reducing the tax impact.
When an index fund needs to adjust its holdings, it can often do so in a way that avoids triggering immediate capital gains taxes because index funds can utilize in-kind transfers, which involve swapping assets with minimal tax consequences.
ETFs share many of the tax-efficient attributes of index funds but come with a unique advantage: the creation and redemption mechanism.
An index fund has to rebalance the fund by selling securities to accommodate redemptions. These sales create taxable capital gains for shareholders (even those who have an unrealized loss on their overall investment).
ETFs deal with inflows and outflows differently and in a more tax-friendly manner. When an investor wants to sell an ETF, it isn’t redeemed by the ETF (like it would be with an index fund). It is sold to another investor just like a stock, which avoids a capital gains transaction for the ETF.
Why tax efficiency is important
Here’s why tax efficiency matters:
Maximize after-tax returns: Investing aims to generate returns that increase your wealth over time. Your returns after taxes can be substantially lower than your pre-tax returns. By choosing tax-efficient investment vehicles like index funds and ETFs, you can maximize your after-tax returns and retain more earnings.
Compound growth: The power of compounding allows your investments to grow over time. Tax-efficient investments can help preserve your gains, allowing your investment principal to compound more rapidly. Over the long term, this can make a significant difference in the growth of your portfolio.
Reduce tax drag: “Tax drag” refers to the reduction in returns caused by taxes. With index funds and ETFs, lower turnover minimizes tax drag and helps keep more of your money working for you. You can also reduce tax drag by utilizing retirement accounts (which include employer-sponsored accounts, traditional and Roth IRAs) because those accounts benefit from tax-deferred growth.
Long-term planning: Tax-efficient investments align well with your financial goals because they allow you to maintain a stable portfolio without the disruption of frequent capital gains events. One of the fundamental principles of tax-efficient investing is to focus on after-tax returns rather than pre-tax returns. While achieving high pre-tax returns might seem appealing, the amount you actually get to keep after taxes is what truly matters in achieving your financial goals.
Lower costs: Tax efficiency is closely tied to cost efficiency. By minimizing taxes, you’re reducing your investment costs. This is particularly important when considering the long-term impact of fees and taxes on your returns.
Risk management: Tax-efficient investments also play a role in risk management. Diversifying your portfolio across different types of investments with varying tax treatments can help mitigate the impact of market volatility on your overall tax liability. By not putting all your eggs in one tax basket, you can create a more stable and predictable financial plan.
Final thoughts
Investing is a carefully considered strategy that should include tax efficiency. Embracing tax-efficient investment vehicles like index funds and ETFs isn’t just prudent. It’s an essential part of a well-rounded investment portfolio.
By focusing on tax efficiency, you position yourself to maximize after-tax returns, reduce costs, enable compound growth, manage risks, and align your investments with your long-term financial aspirations.
At Aura Wealth, we are both financial advisors and CPAs. We integrate our knowledge of taxes into our investment recommendations.
