Discover tax-efficient strategies for mutual funds, ETFs, and SMAs

Taxes can have a meaningful impact on investment outcomes. Tax management is one of many factors investors should consider alongside their goals, risk tolerance, asset allocation, and diversification. Understanding how different accounts are taxed can help investors identify opportunities to manage taxes and potentially improve after‑tax outcomes.

Investors can access financial markets in several ways. In addition to individual stocks and bonds, they may consider the following investment vehicles as part of their portfolio:

• Mutual funds: Professionally managed portfolios of securities such as stocks or bonds. They can provide built‑in diversification and may be actively or passively managed. Investors own shares of the fund rather than the underlying securities.
• Exchange‑traded funds (ETFs): Like mutual funds, ETFs provide access to a portfolio of securities and can be actively or passively managed. Unlike mutual funds, ETF shares trade on an exchange throughout the day.
• Separately managed accounts (SMAs): Professionally managed portfolios of individual securities that can be customized based on an investor’s goals, risk tolerance, and tax preferences. Unlike mutual funds and ETFs, investors directly own the underlying securities in the portfolio.

Taxable, tax‑deferred, and Roth accounts

The type of account can influence when and how investments are taxed.

• Taxable accounts, such as nonretirement brokerage accounts, may generate taxes each year from income, capital gains, and other taxable events.
• Tax‑deferred accounts, such as traditional 401(k)s, 403(b)s, and individual retirement accounts (IRAs), generally allow pretax contributions and investment earnings to grow tax‑deferred until money is withdrawn.
• Roth accounts, such as Roth IRAs and Roth 401(k)s, are generally funded with after‑tax dollars. Earnings and qualified distributions can be tax‑free. A distribution is generally qualified if the account has been open for at least five years and the account owner is age 59½ or older, subject to certain exceptions.

How dividends, interest, and capital gains are taxed

In taxable accounts, investment income and trading activity can create tax consequences. Two common sources are income from investments and capital gains.

The examples below do not include distributions from tax‑deferred accounts, which are taxed differently.

Dividends and interest

Investors can receive income without selling an investment, sometimes called passive income.

Stocks and funds that invest in stocks may pay dividends. Individual companies commonly pay dividends quarterly, although the timing of fund distributions can vary. Dividends are generally taxable in the year they are distributed, whether they are taken in cash or reinvested.

Bonds can generate interest income. How that income is taxed depends on the type of bond and the investor’s circumstances. Interest from municipal bonds may be exempt from federal income tax and, in some cases, state and local income taxes, depending on the investor’s residence and tax situation.

Capital gains and losses

Capital gains and losses occur when securities are sold after rising or falling in value.

If a security has been held for one year or less, the gain or loss is generally considered short term. If it has been held for more than one year, it is generally considered long term.

Short‑term capital gains are generally taxed at ordinary federal income tax rates, while long‑term capital gains may qualify for lower federal tax rates. Capital losses can generally be used to offset capital gains, subject to applicable tax rules and limitations. Investors report capital gains and losses in the tax year of the transaction.¹

Trading activity within a professionally managed portfolio can also have tax consequences. In a mutual fund, portfolio transactions or shareholder redemptions may result in capital gain distributions to shareholders.

Mutual fund location plays a key role in a financial plan

Mutual funds held in tax‑deferred retirement accounts, such as traditional 401(k)s and IRAs, can grow without triggering current taxes on investment activity. Transactions within the account generally do not create capital gains tax while the assets remain invested.

Tax deferral can also help investors manage when taxes are paid. Investors may benefit from tax deferral if they are in a lower tax bracket when they eventually withdraw the money. In addition, tax deferral allows investment earnings to compound without being reduced by annual taxes, potentially supporting greater growth over time.

In taxable brokerage accounts, however, mutual fund investors may owe taxes on dividends, interest, or capital gain distributions even if they do not sell their fund shares. This can make the tax characteristics of a mutual fund an important consideration when deciding where to hold it.

ETFs can offer more tax predictability

Compared with mutual funds, ETFs have historically distributed capital gains less frequently, which can give investors greater control over when taxable gains are realized.

Unlike mutual funds, ETF shares trade on an exchange rather than being bought and sold directly from the fund company. When there is an imbalance between buyers and sellers, Authorized Participants (APs), specialized institutional traders, can help manage the ETF creation and redemption process.

Ultimately, ETFs can be created or redeemed without requiring the portfolio manager to sell securities, which can help reduce capital gains distributions to ETF owners.

SMAs can provide tax savings opportunities

SMAs are professionally managed portfolios that can be customized to an investor’s objectives.

Because investors directly own the underlying securities, an SMA can provide greater flexibility to manage when individual gains and losses are realized. A manager may be able to sell selected holdings for tax‑management purposes while continuing to manage the portfolio toward the investor’s broader investment goals.

SMAs also do not have embedded capital gains from other investors. In a mutual fund, gains realized by the fund may be distributed across shareholders. In an SMA, tax consequences are tied more directly to activity within the individual investor’s account.

Tax loss harvesting can reduce a portfolio’s tax liability

Tax loss harvesting is one strategy investors can use to help manage taxes in a taxable portfolio. It involves selling investments at a loss to help offset realized capital gains.

Opportunities depend on each investor’s portfolio, including unrealized losses, investment holdings, and potential tax savings.²

Investors also need to consider the IRS wash sale rule. A loss may be disallowed if an investor buys the same or a substantially identical security within 30 days before or after selling an investment at a loss.³

Tax loss harvesting can be used with mutual funds, ETFs, and SMAs, but the level of flexibility differs.

• Mutual funds and ETFs: Tax loss harvesting generally involves selling a fund or ETF position and identifying an appropriate replacement that does not violate the wash sale rule. The broad range of available funds and ETFs may provide potential replacement options.
• SMAs: Because investors directly own individual securities, an SMA manager can evaluate holdings separately and selectively realize losses while continuing to manage the broader portfolio. Some SMA programs also offer systematic tax loss harvesting.

Optimize portfolios with tax‑savvy strategies

Taxes are one factor to consider when choosing how and where to invest.

Mutual funds, ETFs, and SMAs can offer different levels of tax predictability, flexibility, and control. Account type also matters. By understanding the tax characteristics of these investment options, investors can optimize their portfolios and retain more of their earnings.