Episode Transcript
Brenton: [00:00:00] The tax implications of how you invest can at times be just as important as the underlying investment itself. In this episode, we go through some of the tax consequences that can come from investing in tools like exchange traded funds, index funds, and mutual funds, and talk about how to determine what's the right mix for your financial portfolio.
Let's get started.
Brenton: Hello, my [00:01:00] name is Brenton Harrison of New Money, New Problems, and your host for the New Money, New Problems podcast.
Over the last several episodes, we've been building up your knowledge base on things like what type of investor you may be, your risk tolerance, how tools like the s and p 500 and other indices may work. In this episode, we want to go a step further in talking about tax implications, because when we started this podcast, I was very adamant about explaining the difference between qualified and non-qualified investments. And I talked about non-qualified investments as that bridge between your cash savings and your qualified and or retirement accounts, which in many cases have age restrictions and other restrictions as to when you can access it.
It is more liquid. Now in exchange for that liquidity, we discussed that non-qualified investments are taxable year to year.
So you have to be more diligent when you're investing in non-qualified brokerage accounts or any non-qualified investment because the activities of that investment when it comes to kicking off gains, can [00:02:00] have a sizable impact on your tax burden at the end of the year, especially if you are a high income earner.
In some of our episodes about taxes, we referenced things like the net investment income tax, and that is an additional tax on investment income of 3.8% for people who have a Modified Adjusted Gross Income above certain levels.
But the point stands that when you have a non-qualified account and you are a high income earner, the tools that you use in that account are very important from a tax perspective. To that end, in this episode, I wanted to talk about the tax consequences that come from three of the popular investment types that you would find for a do-it-yourself investor.
Starting with mutual funds.
As we've covered in previous episodes, a mutual fund is when you put your money into a basket with the funds of other investors, and you pay a mutual fund company to come into that basket and manage that fund by investing it across different securities across different fixed income [00:03:00] tools. So you might have a mutual fund that has ,a collection of stocks and bonds.
There's even funds of funds where you have an overarching mutual fund that owns a collection of other mutual funds inside of it. There are hundreds of type of mutual funds out in the economy, and when you have these funds, oftentimes you can break them down into two different categories. There are actively managed mutual funds and there are passively managed mutual funds.
You recall that we talked about index funds. Index funds are actually a subcategory of mutual funds that would be considered in most cases, passively managed, meaning that they're not trying to make a bunch of transactions throughout the year. They are setting a strategy in which they believe strongly, and they are letting that strategy come to fruition without a lot of human interference.
It is a buy and hold strategy as compared to an active strategy, which is more tactical.
Now, even though an index fund is technically a mutual fund, they kind of stand on their own. So when I reference mutual funds in this [00:04:00] conversation, I'm more so talking about conventional mutual funds where you're paying a team of human beings to make investment decisions on which stocks and bonds or other mutual funds to purchase.
And when you have specifically an actively managed mutual fund, there can be severe tax consequences that can come based on the way many of these funds operate.
As a matter of fact, a common rule that you will hear amongst investors is to beware of end of the year mutual fund purchases, because in the third and fourth quarter of each year, many actively managed funds sell off positions that they've held for a long time at a gain, which produces capital gains tax to their investors. And they also can produce dividends to entice their customers at the end of the year. And if you own those funds at that time, there is a certain amount of that gain that is allocated to you no matter how long you've owned the fund. As an example, if you buy into the fund at December 1st of that year, and then on December 15th, they sell off a number of positions at a large gain, then [00:05:00] you have a capital gains tax, or in some cases an ordinary income tax that may be due based on the results of an activity of a fund that you just bought a couple weeks prior.
And unfortunately, you can have taxable events in these actively managed mutual funds. Even if that fund itself experienced a loss for the year. As a matter of fact, we saw this with some of our clients last year who were looking and seeing that their accounts were down 15, 16% and all of a sudden at the end of the year, they get a 10 99 based on taxable investment income.
And they're saying, how is it possible that I have a taxable consequence from a fund that lost money last year? But that's how many investments work. You can have taxes even in periods of loss, nowhere more so than what you see with actively managed mutual funds.
And it's not just the actions of the fund manager that can produce these taxable results. It's also your actions and those of your fellow investors who have pooled their cash into that fund.
As an example, if you have other investors who want to cash out their shares [00:06:00] of the mutual fund, and even in some cases index funds, that fund manager has to sell shares or underlying securities in that fund to raise the cash needed to make the distribution.
Now, in some cases, they may be distributing something that was invested at a loss, which can actually help your taxes. But in many scenarios, when you have these fund or share redemptions, they are filled based on the sale of securities that lead to a taxable consequence on your 10 And when you get that tax document, it will be partitioned in terms of the type of gain you received. You could have ordinary income, and an example of an investment activity that would produce ordinary income would be if a fund produced a dividend.
A dividend is ordinary income. If they sold something at a gang and they held that position for less than a year and a day, then that gain would also be subject to ordinary income because it's considered a short-term capital gain. And if they sell something that's been held at a gain for longer than a [00:07:00] year and a day, it is a long-term capital gain.
And depending on your income, you would have to pay 0%, 15%, or 20% taxes based on the portion of it that was considered profit.
So, suffice to say I'm not the biggest fan of actively managed mutual funds, but after the break, I'll give you three alternatives that high income investors can use to hopefully aim for growth while mitigating any potential taxes.
[00:08:00]
Brenton: Before the break, I talked about the alternatives high income investors can use to mitigate potential taxes. And I mentioned three. There's actually more than three, but we're gonna cover three on this episode.
And there's two more that I plan to cover in future episodes, but the first of the three we're gonna cover today are index funds. In previous episodes, we've talked about indices like the s and p 500, and that is when you, instead of paying a team of human beings to make [00:09:00] investment decisions throughout the year, You put your money into a basket or a collection with other investors, and there is an algorithm that mirrors the holdings and the activity of an investment index like the s and p 500, or the NASDAQ or the Dow Jones, whatever one you're choosing.
There are funds out there where you are taking some of the, hopefully human error out of the equation, and betting that the diversification of that index over the long term would cost you less and lead to a higher portfolio balance. Now as compared to an actively managed mutual fund, an index fund has much lower fees.
It is not uncommon to find an index fund whose fee is less than a 10th of 1%. So it's a much lower fee, and it typically has less turnover than an actively managed fund.
So in an actively managed fund, that fund manager is making trades all throughout the year trying to achieve an objective and in an index fund there still is turnover. We talked about how in the s and p 500 there is the possibility for a [00:10:00] company to fall out of the exchange in new companies to be added based on the market cap of that company and whether or not it qualifies to remain a part of the index. So there is the possibility that some of the smaller, lower weighted companies in an index like the s and p 500 could fall out and be replaced.
And when things like that happen and there is that small turnover, it produces taxes.
Now an index fund does work like a traditional mutual fund in the sense that when people need to redeem shares, there is also the possibility that that fund would have to sell off underlying securities in order to raise the cash to make the distribution. So it is something that works similarly to a mutual fund in some respects.
It's more a matter of scale in terms of the fact that the impact of an index fund with those same transactions is often much lower.
Now the second option is an exchange traded fund. An exchange traded fund comparatively has a number of advantage when stacked up next to an index fund. The first is the fees are [00:11:00] comparable, but in terms of the barrier to entry, many exchange traded funds will let you enter into the fund for a few dollars, whereas you have some index funds that require a minimum initial investment of $2,000, $3,000 or $5,000 in some scenarios.
So for some, an exchange traded fund is a more amenable introduction into an index fund type of tool. But also an exchange traded fund can be traded throughout the day just like you would fund with a stock. So, whereas in a mutual fund or an index fund, if someone wants to pull some funds out of that investment, those shares have to be redeemed or securities have to be sold in order to make that withdrawal, with an exchange traded fund, you can get out of the position by simply trading it with another investor while the market is open, which means there are less scenarios where you are having a capital gang as a result of selling an exchange traded fund. As a matter of fact, for many exchange traded funds, it is rare to have a capital gain based on the [00:12:00] turnover of the underlying securities themselves.
And there are other positive implications when it comes to the tax treatment of exchange traded funds like the treatment of dividends based on how long you have held the exchange traded fund.
There is the possibility that dividends that are distributed by that fund are treated as qualified dividends. Ordinary dividends are taxed at ordinary income rates. Qualified dividends are taxed at capital gains rates, that zero, 15 or 20% that we talked about earlier in this episode.
So there are a number of reasons that an exchange traded fund is seen as a very tax efficient tool that is not only utilized by doit yourself investors, it's also utilized as a part of larger portfolios that are put into place by investment managers, like ones that we'll discuss in later episodes.
And then lastly, individual stocks. Now, I will tell you that for a lay investor, I am not a huge fan of people investing in single stocks because I don't think that the typical person who's doing it in their spare [00:13:00] time has the ability, the knowledge, the foundation to analyze a company's performance or its potential performance and make informed decisions about when to buy or sell. So if it's a person doing everything on their own, I would probably lean towards an index fund or an ETF as compared to single stocks. But from a tax perspective, single stock investing can be very helpful for someone who's trying to manage those implications,
because with individual stocks, you have much greater control over when you buy and sell certain positions. If you've been holding onto a stock for a long time with a substantial gain and you're trying to minimize taxes, it's your stock.
You would not trade that stock before December 31st because you know that it's going to lead to a long term capital gain. You conversely can sell a stock that you've been holding at a loss to help offset the potential gangs that you could see in other parts of your portfolio.
And as a matter of fact, when you look at really high income, really high net worth investors, Many of whom in my experience use investment managers. When you [00:14:00] dig into those portfolios, you will see that the investment manager themselves are essentially building those investors, their own versions of mutual funds.
They might have 50 to a hundred different singularly owned stocks inside of that portfolio, and the investment manager is making daily decisions on which positions to hold, which positions to sell, but because they're individually owned as opposed to being in an actual fund that might have a hundred or 200 or 500 companies in it, there is more control over those activities and how they impact the end user.
So those are three alternatives that we're gonna discuss today. In the next episode, we're gonna talk about a blend of the index or ETF style investing with the single stock investing by talking to you about a new phenomenon called direct indexing.
We'll dig into it next week. I'll see you then.
[00:15:00]
