Some Taxes On Investments Are "Good" And Some Are "Bad"

Written by Martin Small

Investors should be thinking about ways to use exchange traded funds (ETFs) to help minimize or defer taxes—and keep as much money working in their portfolios as possible. Here's why and how to do it.

Good Taxes

When it comes to your investments, not all taxes are the same. Instead, there are what I think of as “good” and “bad” taxes.

Is there such a thing as good taxes? While paying taxes never feels good, the blow may be softened when they’re levied on a tangible investment benefit, so,good taxes are those paid on a cash return—for example, the income kicked off by dividends or bond interest. These are “bird in the hand” gains, which can be reinvested and allowed to compound, or withdrawn to help meet expenses.

Keep in mind, too, that certain types of income are taxed at less than income rates, which can make a good thing even better. For example, income from U.S. Treasuries are exempt from state and local taxes and municipal bonds are exempt from federal, state and sometimes city taxes. Also, dividends from common and preferred stocks are often categorized as qualified dividend income (QDI), and taxed at a lower capital gains rate rather than as ordinary income. See the table below for a breakdown.

Bad Taxes

Bad taxes, on the other hand, have no corresponding cash return for investors. These arise from capital gains that are realized when any fund manager sells securities within the portfolio to raise cash, whether it’s to purchase new investments or pay for shareholder redemptions. See the table above.

Any profits on these sales are distributed to shareholders, who will owe taxes on it, even if they don’t sell their shares or the fund itself posts a loss. Because it confers no benefit to shareholders, it’s essentially a “phantom” distribution, but it comes with a price tag.

If you think of taxes as an annual cost that eats into your returns—and you should— it makes sense to try to reduce the bad ones as close to zero as possible, while focusing on how to seek investment income as tax-efficiently as possible.

Location, location

Finally, it matters where you keep your assets. For example, capital gains aren’t an issue in a tax-deferred retirement account. The important focus here should be on the right long-term mix of stocks and bonds, and minimizing expense ratios. Meanwhile, taxable accounts should be where investors look to minimize their capital gains distributions while maximizing tax-efficient dividend income.

At iShares, tax awareness is integral to our portfolio management process. Just 4% of our ETFs distributed capital gains over the past five years, on average, helping us to deliver investment performance as tax-efficiently, and cost-effectively, as possible. (Sources: BlackRock, Morningstar, as of 12/31/2016. Past distributions are not indicative of future distributions.)