How to Improve Your After-Tax Returns When Investing Outside of a Retirement Plan

When it comes to investing outside of a retirement plan, such as the Thrift Savings Plan (TSP) or an Individual Retirement Account (IRA), focusing on tax-efficient investments is a critical aspect that can significantly improve your after-tax returns.

Many individuals invest in mutual funds, which are a type of investment vehicle that pools money from many investors and invests it in a portfolio of securities, such as stocks, bonds or other assets. While mutual funds offer several benefits to investors, such as diversification, liquidity and convenience, in many cases they are not the best option for taxable accounts.

Many mutual funds tend to pay out capital gains distributions each year, which can have a negative impact on an investor’s after-tax return. Capital gains distributions are payments that reflect a fund’s realized net gains from selling securities in its portfolio. Mutual funds are required by law to distribute at least 90% of their net investment income and net realized capital gains to their shareholders each year. And unless the mutual fund is held in a tax-advantaged retirement account, investors must report the capital gains distributions on their tax return.

It’s important to understand capital gains distributions provide no economic benefit to investors, even when the distributions are reinvested to purchase additional shares. When a fund pays out a capital gains distribution, the net asset value of the fund drops by the same amount as the distribution. So, although the investor ends up with more shares when reinvesting the distributions, the total value of their mutual fund investment remains the same due to the drop in the fund’s net asset value.

Actively managed funds are handled by fund managers who actively buy and sell securities with the goal of beating a specific benchmark or market index. The ongoing buying and selling of securities (turnover) increase the chances of generating capital gains that must ultimately be distributed to a fund’s shareholders. Passive, or index, mutual funds simply track a market index and have very little turnover year to year, reducing the chance of capital gains distributions.

An even better option than an index mutual fund is an exchange-traded fund, or ETF. Like a mutual fund, an ETF is a type of investment vehicle that allows investors to diversify their portfolios and access a variety of markets and sectors, but there are some key differences that make ETFs the more tax-efficient option.

To improve after-tax returns when investing in taxable accounts, it’s important to focus on investment vehicles that minimize capital gains distributions. If you invest your taxable accounts in mutual funds, stick with passive funds that track broad market indexes, such as the S&P 500 Index (there are thousands of stock indexes) versus actively managed mutual funds.

Most ETFs are index funds, which as discussed, tend to be more tax efficient than actively managed funds. But what makes ETFs more tax efficient than mutual funds – even their index mutual fund counterpart—is the way in which they trade and what’s referred to as the in-kind creation and redemption process.

When a mutual fund investor wants to sell her shares, she must sell them back to the mutual fund company, which in turn must sell securities held by the fund to raise cash to meet the redemption. And to the extent the mutual fund realizes a net gain on the sale of securities, it must pay out a capital gains distribution to the fund’s shareholders.

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ETFs are traded on exchanges like stocks, so when an ETF investor wants to sell her shares, she simply sells to another investor in exchange for cash. The ETF doesn’t have to sell securities and therefore has no gains to distribute to the ETF’s shareholders.

When an ETF company wants to issue new shares of its ETF, an authorized participant (AP) acquires the securities to be held in the ETF and delivers the shares of securities to the ETF company in exchange for equally valued ETF shares. The AP then resells those shares to investors at a profit.

If an ETF company wants so reduce shares of an ETF, the AP purchases shares of the ETF from investors and delivers those shares to the ETF company. In exchange, the ETF company issues securities of equal value “in kind” from the ETF to the AP. No selling, no gains, no distributions.

It’s not what you make, it’s what you keep that counts, and when investing outside of a retirement account, it’s important to utilize tax-efficient vehicles so you can keep more of what you make.

MARK A. KEEN, CFP®, PARTNER, KEEN & POCOCK. SECURITIES OFFERED THROUGH THE STRATEGIC FINANCIAL ALLIANCE, INC. (SFA), MEMBER FINRA/SIPC. ADVISORY SERVICES OFFERED THROUGH STRATEGIC BLUEPRINT LLC AND SFA. MARK KEEN IS A REGISTERED PRINCIPAL OF SFA AND AN INVESTMENT ADVISER REPRESENTATIVE OF SFA AND STRATEGIC BLUEPRINT, LLC. SFA AND STRATEGIC BLUEPRINT ARE AFFILIATED THROUGH COMMON OWNERSHIP BUT OTHERWISE UNAFFILIATED WITH KEEN & POCOCK. NEITHER STRATEGIC BLUEPRINT NOR SFA PROVIDE TAX OR LEGAL ADVICE.