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Alan Haft
Alan Haft
 

A Simple Tax Savings Often Missed

Find out what it is.

February 16, 2010
by Alan Haft

A couple of weeks ago, I was faced with what appeared to be a serious problem: My laptop wouldn’t run.

In a rush to prepare for a media event, I called my self-proclaimed king computer geek frantically who proceeded to race me through a complex list of possible causes. Just when it appeared my trusty Mac was headed for computer heaven, on a last ditch effort he somewhat reluctantly asked if the thing was plugged in.

Glancing at the power source, my face must have turned bright red; indeed, the cause of the problem was that one very obvious thing, leading me to once again realize that sometimes we’re in such a hurry that we can occasionally overlook a few simple things.

When it comes to investments and saving client’s taxes, the “one obvious thing” I occasionally forget to check appears on page one of the 1040, lines 8a and 9a, otherwise known as taxable dividends and interest.

Schedule B

Turning to Schedule B, the culprit causing these taxable dividends and interest is often the result of a client investing in managed mutual funds. Often, but certainly not always, the client is not using these dividends and interest for income. On the contrary, clients are often investing these monies outside a tax-deferred qualified plan and planning to let it sit there and (hopefully) grow for future use.

Although I’m a big fan of some managed mutual funds, when it comes to saving clients taxes, reducing fees and quite often increasing their rate of return, this is the one area I usually first turn to the most.
Often, right there on Schedule B I’ll see a brokerage account and/or some mutual fund company(s) listed that are throwing these taxable dividends, capital gains and interest over to page one of the return. It’s at this point I will often give a client some information on what I call one of Wall Street’s greatest inventions, the illustrious “Exchange Traded Fund,” otherwise known as an ETF.

ETF

If you haven’t heard of an ETF, for yourself and your clients I would highly recommend learning a few things about them. Although it’s rare when I get excited about any investment product, when it comes to ETFs, I’m usually reaching for my seven-year-old’s pom-poms to help sing their praises. Understand, an entire book can be written about ETFs but in the interest of this brief column, I’ll try to keep this real short and hopefully simple.

An ETF is a somewhat related cousin to a mutual fund, but there are a few big differences, perhaps best summarized by the simple chart below. Please keep in mind, these are general points and not necessarily true of every ETF. So, as with any investment, please don’t take these as exact; the points expressed should only be construed as examples. As with any investment, be sure to first understand the exact product before investing in any of them.

  MANAGED MUTUAL FUND ETF
Actively managed? Yes No. Most ETFs are passive investments comprised of an index such as the S&P 500.
Diversified? Typically, yes, within a stated market sector such as “large cap US stocks” or many other choices. Typically, yes, within a stated market sector such as “large cap U.S. stocks” or many other choices.
Can you buy or sell them during market hours? No. They are priced only at market close. Yes. Can buy or sell anytime during market hours. Trades like a stock.
Can you add a level of potential loss protection by strategies such as Stop Losses? No Yes
Who controls buying and selling the holdings within the fund? Fund manager in accordance to the prospectus and objectives. Investor has no control. Positions within the ETF are rarely traded. Investor controls buying and selling of the overall position.
Average cost of holding the position? After sales loads and/or trading costs are applied, the national average to hold the position is generally between one percent and two percent annually, sometimes much more. After trading costs are applied, the national average to hold the position is generally between 0.2 percent and 0.5 percent annually.

Taxes
When it comes to taxes, ETFs can be quite tax efficient. Given most ETFs are passively managed (the internal stocks within the position rarely gets traded), ETFs typically distribute very little capital gains during the year.

In many cases, when I hear a client-investor complain about the amount of tax they are paying, my first question is “are you investing in managed mutual funds outside your retirement accounts,” and the answer is very often, “yes.” By looking at a tax return and carefully researching the positions within the person’s brokerage accounts, I can provide a general assessment as to the tax ramifications the funds are causing.

If you aren’t familiar with ETFs, I would suggest checking out Yahoo Finance and/or ETFConnect.com. In order to become familiar on how you can help your clients, to research a mutual fund’s tax ramifications, above and beyond looking at a tax return, you may want to check out Morningstar and a lesser known Web site called PersonalFund.com. Both of these Web sites offer various insights into a particular fund. When assessing tax ramifications, CPAs should pay close attention to something called “Turnover.”

Turnover

Turnover refers to the amount of times a fund manager sells holdings within the fund. Often, you’ll come across something called Turnover Ratio, which is expressed as a percentage. A Turnover Ratio of 100 percent would mean the fund manager sells all holdings of the portfolio during the year and replaces them with something else. A Turnover Ratio of 50 percent means that half of the portfolio is replaced during the year, etc. Needless to say, the higher the turnover ratio, the more likely it is that capital-gain taxes are being passed off to the client.

Of course, this isn’t to say a portfolio of managed mutual funds should be quickly replaced with ETFs. There are obviously many considerations that need to be taken into account before anything is ever replaced, especially when tax considerations are involved.

Conclusion

When it comes to trying to help clients save a few dollars in taxes — likely pay less fees and increase performance — this is one way to potentially save clients a handful of taxes I personally wouldn’t want to miss.

Do you have any other “obvious” tax savings ideas? If you do, please, drop me an e-mail. I’d love to hear all about them.

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Alan Haft is an investment advisor, author of three books including the national bestseller, You Can Never Be Too Rich and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others.