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

Investing decisions involve many factors, from individual goals and risk tolerance to asset allocation and portfolio diversification. Tax management is a key component of a financial plan, as understanding how accounts are taxed can help investors minimize exposure to taxes and bring opportunities for tax savings.

There are several ways to invest in financial markets. In addition to individual securities like stocks and bonds, investors could consider the following vehicles as part of their investment portfolio:

• Mutual funds: These are professionally managed baskets of individual securities, such as stocks or bonds. They can offer built-in diversification, allowing investors access to a diversified portfolio of securities rather than a single stock or bond. A passively managed (or “index”) mutual fund attempts to replicate an index portfolio through holding the same or similar securities, or a representative sample, at the same proportions as the benchmark index. In contrast, an actively managed fund uses professional portfolio managers to try to outperform the target benchmark. Mutual fund orders are executed at the end of the day, and all investors in the fund receive the same price at the market’s close.
• Exchange-traded funds (ETFs): Like mutual funds, ETFs offer a share of pooled securities. Like a mutual fund, an ETF can be passive or active. Unlike a mutual fund, ETF shares can be bought and sold on an exchange throughout the day.
• Separately managed accounts (SMAs): SMAs are portfolios of individual stocks or bonds, professionally managed based on the investor’s personal financial goals, risk tolerance, and tax preferences. Instead of holding a slice of a group of securities, like in a mutual fund or an ETF, the investor directly owns the professionally managed portfolio of securities.

Asset location, or the type of account, is also key to understanding tax implications:

• Taxable accounts, such as a nonretirement brokerage account, hold securities, and taxation on earnings, dividends, and other taxable events occurs annually.
• Tax-deferred, or tax-advantaged, accounts include mutual fund investments in retirement plans (e.g., generally, traditional 401(k) or 403(b)) where pre-tax contributions grow tax-free until the money is withdrawn. 
• Tax-advantaged accounts also include investments in certain retirement plans (e.g., Roth IRA and Roth 401(k)). Contributions to Roth accounts are generally made with after-tax dollars, meaning investors do not get a tax deduction. However, the earnings and qualified withdrawals are tax-free. A qualified owner is over age 59½, with some exceptions, and the Roth account has been open for at least five years.

Taxable events

Investors should consider taxable events—actions that result in a tax payment or a tax deduction—as they weigh their investment decisions. A few common taxable events are listed below, but this is not a comprehensive list. This list does not include distributions from tax-deferred accounts, as taxable events from these accounts are treated in a substantially different manner.

Passive income (dividends and interest)

• Investors can receive income even without selling a security. Stocks and funds investing in stocks can pay dividends, or a percentage of the company’s profits. The frequency varies based on the individual company but is generally quarterly. Investors can choose to reinvest dividends or receive the payout in cash, but dividends are usually taxable in the year in which they are distributed.
• Similarly, bonds can generate interest income, usually paid semi-annually. Bond funds typically annualize that income and pass it on to shareholders on a monthly basis. How these interest payments are taxed will vary based on the bond’s issuer (corporate, government, or municipal) and the investor’s financial circumstances. Funds or SMAs that invest in municipal bonds may have an additional tax benefit, depending on the individual investor’s residence and tax situation.

Trading activity

• Capital gains and losses are taxable events¹ that occur when securities are sold after they have appreciated or declined in value. If a security is held 12 months or less, the gain or loss is short term; when held longer than 12 months, it’s a long-term capital gain or loss.
• At the individual level, tax rates for short-term or long-term gains vary, and an investor will report a capital gain or loss in the tax year of the transaction. At the professional manager level, buying and selling activity—whether for investment or redemption management reasons—can result in year-end capital gain distributions to all shareholders. 

Mutual fund location plays a key role in a financial plan

Mutual funds held in tax-advantaged retirement accounts (e.g. 401(k), IRA) grow tax-deferred; dividends and interest are taxed at the time of withdrawal. Investment transactions within the account do not incur capital gains tax, provided the funds remain invested in the retirement account. By deferring taxes, investors can potentially lower their current taxable income, which might place them in a lower tax bracket. This can be especially beneficial if the investor expects to be in a lower tax bracket in the future when the taxes are eventually paid.

Additionally, tax deferral allows investments to grow without being reduced by taxes each year. This means the entire amount, including what would have been paid in taxes, continues to compound over time, potentially leading to greater growth.

Mutual funds held in nonretirement brokerage accounts will often incur taxes whether the mutual fund investor sells shares or not, generally making them less ideal to hold within a taxable account.

ETFs can offer more tax predictability

Compared with mutual funds, ETFs consistently distribute fewer capital gains to shareholders, which could make them attractive to investors who seek growth and greater control of their taxes. 

Unlike mutual funds, ETFs aren’t bought and sold directly from the fund company. Instead, shares trade like stocks on an exchange, where buyers and sellers are matched electronically. If there is an imbalance between the number of buyers and sellers, professional institutional investors called Authorized Participants (APs) step in. APs are specialized institutional traders within large financial firms which help to manage the ETF creation and redemption process.

Ultimately, ETFs can be created or redeemed without the portfolio manager selling securities, thereby reducing the distributed gains to ETF owners.

SMAs can provide tax savings opportunities

SMAs are professionally managed portfolios, personalized to an investor’s objectives. These vehicles can also accommodate the investor’s needs, as the investor can instruct the manager to sell specified portfolio holdings for various goals (e.g., tax management, investment growth).

SMAs do not have embedded capital gains. In a mutual fund, there can be a taxable event when the fund manager sells securities to meet liquidity needs. In that scenario, any capital gains are distributed to all shareholders. In an SMA, the investor purchases underlying securities directly. Therefore, an investor is only taxed on gains related to their actions.

Tax loss harvesting can reduce a portfolio’s tax liability

Tax loss harvesting is a strategy of selling securities in taxable accounts to generate capital losses, typically to offset capital gains. Tax loss harvesting opportunities will depend on each investor’s portfolio and an assessment of unrealized taxable losses, investment holdings, and potential tax savings.² Before replacing the sold security, investors must be mindful of the IRS’s wash sale rule, which limits reinvestable assets in similar, but different, investments for 30 days before and after the sale. For example, the investor could sell a stock at a loss and replace it with cash, a mutual fund, or an ETF to avoid the wash sale rule. However, if the investor buys the same stock they sold within the 30-day window, the loss would be disallowed for tax purposes.³

Tax loss harvesting can be done with mutual funds, ETFs, and SMAs, although it is easier to implement with SMAs than with the other vehicles.

• Mutual funds and ETFs are assessed as part of an investor’s overall taxable account. The vast number of mutual funds and ETFs available offer many options to help avoid the wash sale parameters.
• In contrast, an investor owns the entire SMA—meaning, the SMA manager can assess individual holdings and rebalance the account as needed. The SMA offers greater selectivity during the tax loss harvesting process. Additionally, some SMA programs offer a systematic process to executing the trading transactions.

Optimize portfolios with tax-savvy strategies

Investors have many considerations when developing their portfolios, and for accounts that don’t offer inherent tax deferral benefits (e.g., IRAs, 401(k)s), tax implications are a key component to selecting investment vehicles. ETFs tend to distribute fewer capital gains compared with mutual funds, making them a potentially more tax-efficient option. SMAs offer personalized management, allowing investors to directly own securities and potentially recognize tax savings by achieving greater control over tax realization. By understanding the tax characteristics of these investment options, investors can optimize their portfolios and retain more of their earnings.