This is another article in my 2015 tax planning snapshot series where I provide some quick and easy-to-implement tips on reducing your tax liability in the year ahead.
If you invest in actively managed ETFs or mutual funds, looking for a higher than average (vs index fund) return, make sure you do it as tax efficiently as possible by keeping these kinds of investments in a tax-deferred accounts like a 401(k) or IRA. This will then make any taxable distributions, which are more common in actively managed funds, a non-event.
For active funds held in taxable accounts, focus on the fund’s after-tax payoff to make sure it delivers some value-add beyond what an index fund or ETF provides. To find out a fund’s after-tax payoff, first enter a fund’s ticker (e.g VIX) at Morningstar.com and then click the Tax tab on the quote page. That page has historic after-tax gains, as well as the fund’s tax cost ratio, which is the percent of the fund’s return that was lost to taxable investors. Funds with low turnover, meaning the manager doesn’t constantly make trades that can generate taxable gains, typically have lower tax cost ratios.
The best advice about how to handle taxable gains may be to simply keep them in perspective. Long-term capital gains are typically taxed at either a 15 percent or 20 percent rate. That’s usually a lot lower than an investor’s income tax rate. What you’re really doing is prepaying your tax.