Buy ETFs To Beat The Tax Man

David Fabian for ETF Daily writes: With less than six weeks until the end of the year, investors should start doing some tax planning on their taxable investment accounts to ease the burden of capital gains.  Many advisors recommend different strategies to tackle this situation ranging from selling losing positions to gifting investments.  The right strategy for you will ultimately depend on your individual mix of income, deductions, investment vehicles, and other factors.

Mutual funds have also begun to forecast their year-end income and capital gains distributions which may end up being higher than previous years.  A recent Morningstar article pointed to the majority of large mutual fund companies such as Vanguard and Fidelity posting estimates in the 5-12% range for capital gains for 2013.  These are typical of funds with a modest turnover rate and above-average gains for the year.

However, there are instances of mutual funds with large outflows that will be posting excessive distributions that can hurt investors that aren’t expecting it.  The Calamos Growth Fund (CVGRX) is forecasting a distribution that will amount to nearly 25% of its NAV based largely on investor redemptions that forced it to sell appreciated positions.  Other situations that can lead to large distributions are from funds that have changed managers or strategies.  Often times a new manager will want to clean house and implement new holdings that will lead to a big tax bill at the end of the year.

Investors that are considering buying a mutual fund for their taxable accounts between now and year end should check with the fund company to see if they will be susceptible to any large distributions.  The last thing you want to do is enter a new position, only to see it hit you right off the bat with short and long-term capital gains that you will have to declare on your 2013 tax return.  This is even more critical for investors in the top tier tax bracket that will see their capital gains rates increase from 15% to 20% this year.

The most obvious way to avoid this situation is to purchase a mutual fund in a tax-deferred account such as an IRA or 401(k) where the distributions have little to no effect on the owner.   If that is not a feasible solution, another option to consider is swapping that mutual fund for an exchange-traded fund.  One of the benefits of owning a passively managed ETF is that they do not have a high degree of portfolio turnover and are less susceptible to large year-end distributions.

Both Vanguard and iShares have recently posted preliminary capital gains estimates that include only a small percentage of funds that are mostly fixed-income related.  The widely held iShares Aggregate Bond ETF (NYSEARCA:AGG) and Vanguard Total Bond Market ETF (NYSEARCA:BND) are on the list with very minimal capital gains distributions that amount to only a few pennies.

A look back at equity oriented ETFs such as the iShares S&P 500 ETF (NYSEARCA:IVV) or the Vanguard Total Stock Market ETF (NYSEARCA:VTI) shows that neither of these funds has paid a distribution other than ordinary dividends for as long as the company has posted data.  This is mainly due to the fixed nature of the underlying index which dictates that the ETF hang onto the same stocks for long periods of time.  This makes them extremely tax efficient for your portfolio no matter when you purchase them.

Even an actively managed ETF such as the PIMCO Total Return Fund (NYSEARCA:BOND) which has a much higher degree of portfolio turnover, is only anticipating a short-term capital gain of $0.41 per share.  That equates to just 0.39% of its current NAV.

While the majority of ETFs are tax efficient, it still pays to research your options and key in on any potential red flags.  One of the hidden pitfalls of investing in certain commodity-related ETFs is the tax ramifications of their legal structure. What I am talking about here is the difference betweenan ETF that is structured as a trust that generates a 1099 vs. being structured as a partnership that generates a K-1.  The addition of a K-1 creates a headache for taxable accounts that must be dealt with on your year-end tax return.  To avoid that mess, you can often times find a similar commodity index in an exchange-traded note.

I never recommend investing solely with taxes in mind, but it does help to understand some of the ramifications that can occur without solid due diligence.  It’s all about the right timing and security selection to meet your goal and avoid any unintended tax burdens.   For the most part, ETFs offer an efficient way to reduce the impact of long-term capital gains for new money that you are looking to put to work this year.