Firms tout funds’ tax efficiency, but is their word their bond?
With tax changes looming in Washington, investors sitting on market gains have been struggling to decide whether to pay now or risk higher rates later. But holders of some fixed-income exchange-traded funds may not fully control that decision.
While exchange-traded funds have long been marketed for their tax benefits, this year a slew of bond funds from top providers including Vanguard Group, Pacific Investment Management Co. and iShares could oblige fund holders to pay capital gains taxes on a slice of their investments — even if they simply hold onto the funds.
Experts say the outcome is partly the result of the unique mechanics of bond ETFs and partly the result of strong bond prices. To be sure, the large majority of ETFs won’t saddle investors with any taxable gains this year. When investors do owe taxes, it is likely to be only on a small portion — typically a few percent — of the value of their overall investment.
Industry insiders also stress that bills can be avoided altogether by holding bond funds in tax-deferred accounts like a 401(k). Many bond fund holders are likely already doing that regardless of capital gains situation, to avoid heftier bills on interest income, according to Joel Dickson, a principal at Vanguard Group, which expects to pass out capital gains on 12 of its 13 bond ETFs.
His take on Vanguard Extended Duration Treasury ETF EDV -0.60% , which will distribute capital gains equal to about 3% of its value: “If anyone is holding that in a taxable account they are crazy to begin with.”
Too good to be true?
Still, it isn’t supposed to work this way. Traditional mutual funds frequently oblige investors to pay taxes on capital gains taxes early. But exchange-traded funds aim to solve that problem because of a special design feature that allows fund managers to wipe gains from their books. The advantage is one that ETF providers haven’t been shy about, long touting tax benefits, along with lower costs, as a key reason for investors to switch from mutual funds.
The tension has led some ETF firms to send mixed messages lately. Earlier this week iShares published a press release bragging that “98% of iShares ETFs” passed out no capital gain. (The exact number was 275 out of 280; the five that did were all bond funds.). At the same time the release cited a study that iShares’ parent BlackRock Inc. commissioned earlier this year suggesting its customers expected better: A majority didn’t understand that they faced any tax risk at all. “Many investors are surprised,” the company concluded.
It’s not hard to grasp the basic premise of capital gains taxes — you owe Uncle Sam on profits you make after selling an asset that’s gained in value. One wrinkle that’s long frustrated fund investors is that, unlike shareholders of individual stocks, they can be taxed before they sell.
That’s because when portfolio managers reap trading gains, they’re required to pay these out to shareholders by the end of the year. Even if this money is immediately reinvested in the fund, a shareholder must report them to the IRS and may owe a tax bill.
Rates can be hefty: Short-term capital gains — those on assets held less than one year — are taxed as ordinary income. Long-term capital gains get a better deal, at least for now, with a maximum rate of 15%. But there’s a good chance that could rise as a part of any budget deal to avoid the so-called fiscal cliff. Speculation has led some investors to consider trading sooner rather than later to lock in the lower rates, although financial professionals are divided on the wisdom of such a move. Read more about fiscal cliff tax strategies.
Under the hood
Exchange-traded funds have several advantages over conventional funds that typically help them avoid these tax pitfalls. One is that most ETFs are index funds. Since popular benchmarks like the Dow Jones Industrial Average DJIA +0.03% and the Standard & Poor’s 500-stock index SPX +0.02% rarely change, managers can keep trading to a minimum.
Another big advantage is a tax code provision that allows ETFs to eliminate unrealized capital gains when investors exit the fund. Traditional mutual funds typically hand cash to departing investors — often selling shares from the portfolio in order to do so. By contrast ETFs answer these requests from institutions and other large investors by delivering blocks of stocks and bonds in the portfolio. Big investors that want cash must sell these securities on their own.
This difference may seem arcane, but it has big consequences from a tax perspective: Shares that are sold by a fund triggers a capital gain; those that are handed out “in-kind” don’t. So not only can ETFs avoid selling when traditional funds might have to, it also gives them an opportunity to part with shares likely to prompt the largest taxable gains. The process is something industry insiders such as ETF website IndexUniverse.com director of research Dave Nadig call “the magic” of ETFs.
What’s going on with the bond funds then? Sometimes the magic doesn’t work so well. ETFs that buy a stock might hold it forever. But bonds are continually approaching their maturity date, so fixed-income managers don’t enjoy that luxury.
Moreover, because some types of bonds are hard to trade, bond ETFs sometimes traffic in cash like traditional funds, losing the chance to eliminate gains. Finally, bonds have rallied in each of the past five years, so many funds are sitting on gains. “You’ve seen a continued bull market,” says Morningstar ETF analyst Ben Johnson.
How big is the tax hit? While it depends on a number of individual factors, consider this back-of-envelope calculation for Pimco Total Return ETF BOND +0.08% , which has quickly become one of the most popular bond ETFs since hitting the market earlier this year.
The ETF expects to distribute gains amounting to about 0.77% of its overall value this year. (Pimco expects 14 of its 19 bond funds to pass out gains of some kind.) A wealthy investor with $250,000 in the fund — not outrageous considering it’s designed to be a core part of investors’ portfolios — would owe taxes on a $1,925 capital gain. Since the fund plans to pass out a short-term rather than long-term gain, the investor’s tax obligation matters. Assuming the top 35% bracket, the tab would come to $674.
That’s not likely to break the bank. But for some investors, it might break a bond.