An ETF Tax Swap Idea for the Holidays!

Subscribing to my site guarantees you don't miss any new content. Choose either E-Mail Feed or RSS Feed. Thanks for visiting!

Many mutual funds distribute their capital gains near the end of the calendar year, typically in November and December.

If you’re a mutual fund shareholder, it’s important to check with your fund family to see whether or not your fund is going to have a capital gains distribution at year’s end; if so on what day it will occur.

Many funds will give you an estimate ahead of time, detailing the size of the distribution. Here’s a link to a page that details the different short and long term capital gains for the fund family ING and when the fund distributions will occur.

As you can see, there’s a huge difference between the total capital gains for the ING Diversified International Fund (.17%) and the ING International Small Cap Fund (7.89%). Do you think it might be important to be aware of something like that if you’re an ING fund holder? I’d say so.

Different shapes and sizes

Now this all ties in directly to the tax efficiency of your particular mutual fund and to the portfolio turnover of the underlying fund assets. I’ve written extensively about some of these issues in the past. Some of the tell tale signs of a fund that may distribute large gains are:

• a fund with positive returns
• a fund with high portfolio turnover
• a fund that invests in more aggressive/more volatile areas of the market

(this may not always be the case, especially if a fund is carrying losses on the books that will wash the gains. But if a fund is consistently turning over the portfolio, not only are they passing higher fees on to you, but chances are, capital gains as well.)

A quick look at recent capital gains history

After the great performance many funds returned in the late 90’s they were weighed down by capital gains that were unceremoniously dumped on investors. Some unsuspecting investors would buy into a fund and get hit with a Mack truck of capital gains right out of the gate. That’s why it’s so important to meticulously screen mutual funds before purchase.

My motto

“When choosing your investments, you want to put a premium on tax efficient funds with low expenses. At the end of the day you can only play a part in controlling your costs, the performance will have to take care of itself.”

With all the above said, I don’t think it’s going to surprise anyone that the overwhelming majority of my client portfolios consist of ETF’s. When it comes to tax efficiency there’s nothing better than ETF’s. So here’s a tax swap idea for the holidays…

A holiday gift idea

If you own an actively managed fund and know your fund is going to distribute a large capital gain (or if you want to realize a tax loss) now may be a good time to switch into an ETF.

By switching now, you can:

1. avoid the capital gain distribution and the associated tax consequences.
2. replace that investment with a correlated ETF. The iShares site has a correlation calculator that allows you to enter the symbol of your current investment. The calculator returns the ETF’s most closely correlated to the investment you’re looking to replace.
3. You can avoid the impact of wash sale rules*. Sell the old investment and buy the ETF immediately, this way you don’t miss out on any time invested or distort the portfolio asset allocation.
4. realize a capital loss (if you have one) that can be used to offset up to $3,000 of reportable income (or can be carried over indefinitely to wash future gains, a huge tax benefit)
5. begin the migration to the most tax efficient investments in the marketplace.

In point #3 above I talk about avoiding the wash sale rules. Please realize this is a much debated topic. In fact, there is a never ending discussion when it comes to whether or not a sale and subsequent ’substantially identical’ purchase, triggers a wash sale violation or not.

In the clear

In the above example I’m talking specifically to moving from an actively managed mutual fund into a passively managed ETF. This should not trigger a wash sale violation.

Reasonable minds disagree

On the other hand, moving from a tax efficient mutual fund (like Fidelity’s FSMKX) into a tax efficient ETF (like SPY) may be a different story, although that’s a moot point for the purposes of this post. I wouldn’t recommend such a thing.

This post is specifically geared towards moving away from inefficient actively managed mutual funds into passively managed ETF’s. This tax swap shouldn’t bring the wash rule into play at all.

But ofcourse, please consult with your tax advisor before making any decisions based on anything I’ve written. And for good measure here’s a link to the official IRS page that speaks to wash sales. When you get there just click on the heading ‘wash rules’ and it will take you to that section.

I’d like to wish everyone a Happy and Healthy Thanksgiving!

Tags: capital gains distribution, ETF, Exchange Traded Funds, Mutual Funds, Tax Efficiency