Stock Funds and Taxes: Long Term Advice from a Top Expert

12/31/2019 5:00 am EST

Focus: FUNDS

Jack Bowers

Editor, Fidelity Monitor & Insight

There’s no question about it: a lot of investors are frustrated by higher tax bills on their non-retirement accounts and are looking to “fix” the problem, explains Jack Bowers, editor of Fidelity Monitor & Insight.

But I would argue that their goal should be to maximize after-tax returns, not minimize current tax liability. Why? Because focusing too much on the latter can lead to poor performance and increased portfolio risk. Below are a few common tax assumptions by some investors that are not always correct.

• Long term capital gains distributions cause higher tax bills. While this can be true if you haven’t sold the fund yet, for every dollar of gains you are taxed on, there will be one less dollar of gains to report when you sell the fund. Thus, the total taxes you pay from purchase through sale are about the same.

And if capital gain rates climb over the long run, those payouts may actually save you some tax dollars. Another way of looking at it: distributions let you “pre-pay” tax on your unrealized profits so you can take advantage of today’s low rates on long-term capital gains.

• ETFs aren’t taxed as heavily as mutual funds. It’s true that passive ETFs allow you to minimize capital gain distributions. But if you realize a $10,000 gain from the sale of a passive ETF, the total taxes you pay will be very similar to realizing the same gain from an active mutual fund.

The only exception: if the mutual fund distributes a significant share of its profits in the form of short-term capital gains, you’ll pay more.

• Active fund managers cause higher tax bills. This is sometimes true, but it’s the exception rather than the rule at Fidelity, where the vast majority of stock fund profits are distributed in the form of long-term capital gains.

And in that situation, the total taxes you pay after selling the fund will be very similar to the taxes you would pay with a passive ETF. It might even be less in a situation where the investment vehicle is held for less than a year.

• Tax-efficient funds can lower your tax bill. This is true only if the fund remains tax-efficient and you hold it for the rest of your life. Otherwise, any taxes you defer simply accumulate and become due when you sell the fund (a more accurate description would be “deferral efficient” because the tax liability is delayed, not reduced).

I’ve often described our model portfolios as “pay-as-you-go” when it comes to taxes. That’s because other than the Growth Model Portfolio’s objective of trying to hold profitable positions for more than a year, our primary focus is to build wealth over the long run.

In contrast, trying to minimize investment-related taxes for the current year is more about pushing today’s tax obligations into the future (in that respect it’s not much different from taking on zero-interest debt). And I’ve never felt that it makes sense to allow the tax tail to wag the investment dog.

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