Are Taxes Hurting Your Investment Returns? | The Informed Investor 17

Episode 17: Are taxes hurting your investment returns?

Investors holding mutual funds and exchange-traded funds (ETFs) in taxable accounts seek to capture high after-tax returns, not just rewarding pre-tax returns.

But achieving that goal depends on how the funds are managed.

Using efficient portfolio design and tax-smart implementation, some funds are able to limit capital gains and income distributed to shareholders. That approach limits the taxes they have to pay.

One tool funds can employ is low turnover (the portion of securities bought and sold). Limiting how often and in what fashion securities are sold can lower capital gain distributions for investors.

Capital gain distributions may be either short-term or long-term in nature. Long-term gains are typically taxed at lower rates. Short-term gains are generally taxed at higher rates.

Another tool used by tax-efficient funds is what's known as in-kind redemptions.

In the case of ETFs, shares of the fund are created and redeemed in the primary market through a process between the ETF provider and authorized participants (APs), which are large institutional investors.

When securities are exchanged for ETF shares (creation units), this is known as an in-kind transaction. An AP may place an order directly with the ETF provider to purchase creation units of ETF shares in exchange for securities and/or cash that constitute a creation basket defined by the ETF provider. In the case of a redemption, this process works in reverse.

When an ETF uses in-kind redemptions, appreciated securities transferred out are not recognized as capital gains for tax purposes and, therefore, do not impact end-of-year fund distributions for shareholders.

While commonly associated with ETFs, in-kind redemptions may also be used by mutual funds.

Dividend income distributions are another important component of overall tax costs. They are classified as either qualified, which are taxed at a lower rate, or nonqualified, which are taxed at higher taxes.

Funds that distribute higher proportions of qualified dividend income (QDI) can reduce investors' overall tax costs.

In Episode 17 of "The Informed Investor," Dimensional's Mark Gochnour, Head of Global Client Services, Rob Harvey, Co-Head of Product Specialists and a former Dimensional portfolio manager, and Jake DeKinder, Head of Client Communications, go in depth on how investments are taxed, why some funds hit investors with large taxable distributions, and which tools funds may use for maximizing after-tax returns.

LINKS FROM TODAY'S EPISODE:

The Informed Investor on YouTube https://www.youtube.com/playlist?list=PLCyJr6FFig-h1mA7rVP7Mbk0irFw2wA90

Mark Gochnour on LinkedIn https://www.linkedin.com/in/mark-gochnour-9a23598a/ Rob Harvey on LinkedIn https://www.linkedin.com/in/robkharvey/ Jake DeKinder on LinkedIn https://www.linkedin.com/in/jake-dekinder-cfa-4105b98/

Learn more at https://www.dimensional.com/