Are Taxes Hurting Your Investment Returns?

Welcome to "The Informed Investor", where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Welcome to "The Informed Investor", and today Jake is taking over moderating duties. Jake DeKinder. I am taking. Welcome to "The Informed Investor," I'm Jake DeKinder, very pleased be joined by my colleagues, Mark Gochnour and Rob Harvey. This show is brought to you by Dimensional Fund Advisors, a global asset manager with over $915 billion under management and a company that brings financial science to the world of investing. But I do wanna introduce Rob Harvey, Co-Head of Product Specialists here at Dimensional. It's great to have you on the program and- Yeah, thanks for having me on the pod. You spent a lot of time here at Dimensional and in a lot of different roles, so you bring a really good perspective. I mean, you spent time in London office- Mm-hmm. US offices, been managing a lot of portfolios. Do you know why I'm hosting today versus Gochnour? It's because of his passion for the topic, isn't it? He is gonna totally geek out- Yeah. Because we're talking taxes, baby. Yeah. And he's gonna totally geek out on this one. That's his gem. You're fired up for this one. I am fired up for this one. I love it, I guess it goes back to my old days as a CPA. And by the way, you passed the CPA as well. I did. I didn't do all the work requirements and all that, but I did get my master's in Accounting, sat for the CPA exam, so I can geek out a little bit with you. Yeah. Well- Okay. How'd you get in the room today? I have my CFA, you have to do some- Yeah. Accounting for that. I guess, it's a lucky day for you to- It's the worse part. Two CPAs, I think. Yeah. Okay, this is gonna be a fun one on taxes. All right, it is a great topic. It's a great segue. And it's a really important topic. Why are we talking about right now? This is incredibly important topic. This time of year, why are we talking about it? This time of year. So this is distribution season. Yep. And by that, I mean, the estimates for asset managers are coming out typically, you start to get those in October, November. Mm-hmm. And then distributions are made in December. And so we get a lot of questions here at Dimensional around the distributions. But again, the asset managers are usually coming out with estimates, helping investors then think through their year-end tax planning. So a lot of headlines coming out now around distributions, a lot of questions, so it's just a good time to address it. I like that. Was that a subtle reminder that as I do your job, I'm supposed to read the headlines? Yes. See, it's harder than- Good segue. There you go, I got a couple here for you, okay? Exchange-traded funds have a tax magic that many mutual funds don't offer. And actually we're gonna get- Mm-hmm. Into a little discussion about vehicle type, mutual fund versus ETF- Mm-hmm. Couple of other ones here. Qualified dividends versus ordinary dividends. How are dividends taxed? Which again, we're gonna get into that one. Yep. I love it. Yep. And then, are active ETFs truly more tax-efficient? I actually think those three set up really nicely for our discussion. They do. Yeah, we've got a lot to talk about for each and every one of those, so. Let's start at a high level because I think a lot of people actually do think about tax. Well, I think everybody kind of considers taxes, right? But on the investment side, a lot of people think about my 401 or some type of qualified account. Right. Right off the bat. So people are thinking about this, correct? They are thinking about this, and there's lots of different sort of avenues you can take from that high level decision. But to your point, right off the bat, qualified versus non-qualified, that is an important aspect already about what kind of investments are you holding, and what does the taxable account look like? Or in other words, what are you holding in there, and how tax-efficient is it? There's a lot of decisions that get made beyond that, but first and foremost, if you have a 401, if you have an HSA or if you have a brokerage account, you already know about a lot of this stuff or you're already thinking about it. There's a lot more depth we're gonna go into, but high level, that's absolutely right. So we're not really gonna spend much time on that qualified. Right. Because whether it's after-tax dollars that go in, pre-tax dollars, how it grows, how it comes out, there's all of that. People should be considering that if they have that option. Yes. We're gonna focus on the taxable side. Hmm. And Mark, when we go to the taxable side, what is it that you get taxed on? Like what are the different types of taxes you can get taxed on inside of an investment? Well, and it goes back, let me just set it up and go back to the timing again. Yeah, yeah. I wanted to mention this one too about how distributions come out in December. Yeah. And largely that's a big interest because that's where capital gains come out in those estimates. Yep. Right, you get quarterly income distributions. Usually the industry will distribute capital gains for the most part in December. And then in January, we get our 1099 reporting- Mm-hmm, mm-hmm. Which breaks out the type of gains you have in those taxable accounts. And that's exactly where you're going there, is what are these different- Mm-hmm. Types of a taxable event. And so usually there's two major ones, you got the capital gains. Mm-hmm. Right, which is a realized gain on the sale of a stock or a bond, and then you get income. And that can mean different things depending on the strategy. It could be the dividends you receive, it could be the interest income. Right. On bonds, it could be even some income you receive from securities lending. Right. Revenue. And we're gonna get into it. And this is where I like the topic so much is the industry focuses so much on capital gains, and they should- Mm-hmm. Because it's incredibly important, but there's very little conversations on how to manage income. Yeah. And that in some cases can be just as important- Yep. Is managing capital gains effectively. So those are the two big ones there that we'll be diving into here today. Yeah. Okay, so let's talk a little bit about the gain side of it first, let's go there. Yeah. So you and I were talking about this earlier, from a gains perspective, there are things that an investor can do to influence what their gains are like. Mm-hmm. And then there are things that happen inside the investment product- Mm-hmm. To mitigate capital gains. So we were discussing this earlier, but if you're an investor who is buying and selling a lot of different stocks, meme stocks, for example, or maybe you've got opinion on crypto or maybe gold, right? Those things are very volatile, they're moving quick. Or even buying and selling ETFs. Or even buying and selling ETFs, right? Yes. You will take capital gains if your investments have done well. Mm-hmm, mm-hmm. Right. And that's a bill you're gonna have to pay. Yep. So there is the decisions that are being made by investors in these vehicles, but then there's also, well, if you are... If you do have a longer holding period, maybe something that's a core part of your portfolio, what's happening inside of that investment vehicle to mitigate some of those capital gains. Yeah. Which are ultimately gonna be distributions, right? If it's not careful, if the manager is not doing a good job thinking about them, that's gonna be a bill for you. It's gonna be a really big bill for you as well. Mm-hmm. And, I mean, Mark, if we think about like the rates that we can potentially get taxed, and I know you wanna go to the income side, but let's just kinda think- Mm-hmm. About just the gain side of it. Walk us through some of the rates that people have to be considering because- Mm-hmm. If you go from short-term to long-term, it can be really big in terms of the difference on what you're going to pay. Yeah, two major rates that we look at here. So what you'll find is the capital gain rate on long-term gains is 20%, but then there's also this thing, which adds another 3.8% to capital gains. So long-term gains will be 23.8%, and then short-term gains are taxed as ordinary income. Now again, the guidelines dictate that for ordinary income, you use the highest marginal tax rate- Mm-hmm. Which is 37%. Mm-hmm. So the tax rate then on short-term gains will be that 37% plus the 3.8%, so it'll be 40.8% in total. And then similarly on the income side of things, qualified income will be taxed at that 23.8%. Mm-hmm, mm-hmm. Non-qualified income will be taxed at that 40.8%. So we'll get into how to think about managing those a little bit here. But those are by and large, what we'll be using here is 23.8% for long-term capital gains and qualified income. Yeah. 40.8 for short-term gains and non-qualified income. I think it also surprises a lot of people that they may continue to hold a fund and yet there's gains that they might have to potentially pay, right? And that's because the fund is, it's a company, correct? And I mean if you invested in any type of company and they had a gain, like you would have to pay that as an... That's what's going on, correct? Yeah, it's a good point. And we're kind of bouncing around a little bit between an investor holds an ETF or a stock, right? If they buy or sell that, they're gonna have a capital gain. Right. Assuming hopefully there's an increase in value. Right, right. But if they continue to hold, they can still have to pay, correct? Yeah, so then if you talk about an ETF or mutual fund, the managers are holding 10, 20, hundreds of thousands of securities. Right. Within those. And they may be buying and selling depending on the objectives of the portfolio. So they're realizing capital gains, they're earning dividends and earning potentially income in there as well. So you're absolutely right, those capital gains, the income earned within a fund, mutual fund or an ETF are required to be distributed out to the shareholders. Mm-hmm. Mm-hmm. And then that's where these estimates come in that we've been talking about here. And then what you're gonna have is on record date, which is usually in December. Okay, what's record date? So record date is when, if you are a owner of that mutual fund on record date, then you'll get the distribution. Typically the following day you have what is called X date, and that's when then the fund distributes those realized gains in the income, and that's where you get that drop in NAV. So let's just remind folks, when you get a dividend or a distribution, the NAV drops just like you do if you have an individual stock, right? The stock price drops by the amount of the- And we had an episode- Distribution. On that. And we did an episode in that. Yeah. That's right. In fact, I think it was one of our first episodes. I think it was one of the first ones, yeah. That we did there. So just as a reminder, when you get a distribution, the NAV or the price of the mutual fund, it drops by the amount of distribution. You still have the same overall wealth. Mm-hmm. Right. Dollar value of wealth. Mm-hmm. It's just that share price drops by that. Yeah. So we just always wanna remind people about that 'cause we still sometimes get questions of, "Man, what happened yesterday?" Yeah. Where we just had the distribution. Exactly. Yeah, we do every year. Exactly. Okay, so I wanna talk about the vehicle type. I wanna talk about ETFs versus mutual funds. Mm-hmm. Because the general narrative out there is one's tax-efficient, maybe one's not tax-efficient. Just start with the ETF side of it, and historically why has that argument been made? Yeah, so first of all, I wanna go back to something we talked about earlier. When you have gains, it's because the fund did well- That's a good- Right? So we're looking at this in an environment of, let's say, the mutual fund and an ETF both did well. Right. That's a good thing, right? Now you have gains. So how are those treated differently in the different funds? Well, ETFs have a mechanism called create and redeem. So it happens when you're sort of moving shares out of the ETF Mm-hmm. Or into the ETF. And when you move it out, you can move low-cost basis stock out of the ETF without taking- So ones that would have- Capital gains. Potential gains. Ones that would have big gains. Yes. Right, if you were to sell them on markets. Unrealized. Unrealized gains. Okay. So what we were talking about before is as an investor, your cost basis in the ETF stays the same. So you still have gains in the ETF, but you're not taking a distribution because the fund hasn't actually sold something on market. And this is what gives the ETFs their sort of tax advantage from the distribution side. Mutual funds are kind of thought of as being less tax-efficient, but they do have that tool available to them. The in-kind mechanism is really the big difference between the two, and it's one of the reasons why retail investors or taxable investors tend to prefer ETFs over mutual funds. Yeah, that makes sense. Now we should say that when you don't get those gain distributions in an ETF, or in the case that you explain in a mutual fund. Yeah. Then your basis isn't going to go up over time. It's not that you're going to avoid those taxes. Yep. The government at some point is going to want their money. They will get their money, that's right. It's just you're not paying it each year in the form of gain distributions. Right. But down the road, you could pay more- You could. Barring the fact that you get a step-up in basis at death. Right, generational wealth transfer, that's possible, right. We'll talk about this with income by the way Yeah. 'cause this is not how income works. Mm-hmm. Your income is a bill at the end of the year, but you're right there, it doesn't sort of magically make the gains disappear, they're embedded in the cost basis or in other words in the value of that investment versus where you bought it. Right, so there is still an accumulation of the gains, you're just not getting that bill at the end of the year. Yeah, I always like to think you're deferring them into the future. That's right. Yes. And so when you sell that ETF- That's right. That's then when you pay the capital gains on that, that value. Right. Okay. So we we're sort of talking about gains inside of the vehicle there. We should make one other note too is, is that at least a high level, I think you guys are kind of talking about stock portfolios or bond portfolios, gains inside of there. So you just gotta understand what's going on inside of there and why you may be paying either long-term or short-term gains depending on how the fund is being managed, and the type of investments they have. So we've talked about the gains part of it, and how we have to think about it. I wanna come back to the income piece because you mentioned this at the top, that the industry does tend to focus on this gain side over here, but the income can be really important, and it can get taxed in- Hmm. Different ways as well. It absolutely can. And I think there may be a view out there that's like, well, it's just income, we all get it, and it is what it is, but it doesn't necessarily have to be that way. There are things you can do to really bring a more tax-efficient approach in the way you're managing that income, but let's go back and think about how do we even measure the effectiveness of a manager when it comes to their ETF or their mutual funds. And so there's a couple of things that I think the industry likes to look at there to see, is my particular mutual fund or ETF tax-efficient? So one of them we just refer to as tax cost. Mm-hmm, mm-hmm. That's simply the difference between your pre-tax return- And your after-tax. Minus your after-tax return. Right. On those distributions. So that difference is really how much you're losing in your return to taxes. Right. So that's one measure. And then the other one is, we call it the tax efficiency ratio, which is simply my after-tax return divided by my pre-tax return. And that is telling you the percentage of my total return that I'm keeping- Mm-hmm. And after-tax. Yeah. So let me just give a couple of numbers- Mm-hmm. Sort of give some context to what we mean by those numbers here. So I'm gonna look at a couple of these major asset classes that we have there, and the data I'm mentioning here is coming outta Morningstar. And these are gonna be one year numbers as of September 30th, just to give some perspective here. So here's some numbers here. So let's look at the asset class large blend, and the tax cost over the one year number has been 1.42%. So that means whatever the pre-tax return was, lower that by 1.42, and that will be your after-tax return, so that's your tax cost. And then corresponding to that was a tax efficiency ratio of 87%. So sometimes it's easy, you need to scale by something- Mm-hmm. Right. To get comparisons here. Right. So that's the tax efficiency ratio. Now let's contrast that with the small value asset class here in the US. So that tax cost is 1.79, so quite a bit higher than that 1.42- Mm-hmm. We looked at, and the tax efficiency ratio dropped to 54%. Mm-hmm. Big drop, and we're gonna talk again about the things you wanna keep in mind in what drives that- Right. That lower number- Yeah. Particularly around income. Yeah. And then just to give context outside the US, let's say with, in this case Morningstar's categories, foreign mid cap, small cap value that goes up to 1.86%, is the tax cost, which is about an 89% tax efficiency ratio. So just to give some numbers in terms of the way we think about the impact of taxes on those different asset classes. Yeah, and those are big numbers too by the way, right? You think about shaving 10% or more off of your returns in terms of what you're taking home, it's important, right? It's worth focusing on, so I think that's- And that's why I love the topic. Yeah. Is it can have a huge impact negatively- Yeah. On your returns if you're not managing your taxes effectively. So when you move from something like, I think you said large blend- Mm-hmm. Right? Which are bigger stocks that are kind of out there into smaller stocks you referenced, then you moved outside of the US. As I change those categories, I go to small and then I go, I was like, what is it that could be driving some of those numbers? I mean, walk us, is it turnover? Is it what they hold? Is it something else that's going on in potential taxes, especially when you get outside the US? What's happening there? Well, and this is where I'm gonna bring Rob in. And by the way, Rob was a portfolio manager. Yeah. On many of the different equity funds in the UK. Mm-hmm. Our UK office- Yep. As well as here in the US- That's right. So just get perspective globally. Different taxes. Yeah. Still taxes over there though. Different types of taxes. Mm-hmm. And so you're absolutely right, Jake. It could be the turnover, like how much you're buying and selling- Mm-hmm. Within the fund. It could be the type of securities 'cause they have different tax treatments, so- Yeah. Let's get your perspective here, Rob, on some of the things that come into play there. Right. I mean, turnover is important, and it's also about when do you take that turnover, and what are you turning over, right? So if you look at a fund that has maybe 5% turnover in a year, that doesn't necessarily give you the full story because we talked about long-term and short-term gains before, right? So if you have a manager who is holding the vast majority of their portfolio, but they're trading in and outta meme stocks, for example, and that's the 5% turnover, you got short-term gains in there. Mm-hmm. So that's gonna impact you differently than if you had really looked at that 5% turnover and thought, where can I realize losses? For example, April of this year. If you took turnover in April of this year, you had a chance of realizing some losses, which is good, right? Mm-hmm. Ultimately you just wanna kind of crystallize that and lock that in a little bit. So it's about when, it's about how much, it's about which stocks, right? In terms of the cost basis are also being traded with the turnover, so that's true. But then the types of investments are also incredibly important. Mark, we talk about this all the time, but there are certain types of investments that have more advantageous tax treatment than others. And for us thinking about which type of vehicle, we mentioned this before, qualified versus non-qualified, is important to consider where am I holding these investments? REITs, for example. Mm-hmm, absolutely. PFIC, passive foreign investment companies, is another good example of just things that are gonna throw off a little bit of a higher tax bill. And so you have to be conscious about where you're getting that exposure. And by that you mean like REITs, for example, the income coming off a REIT that the fund earns, and again by IRS guidelines, that's taxed as non-qualified income, right? So that's taxed at that 40.8%- Yes. Rate, right? As opposed to the 23.8% of regular dividends. So to your point about, if REITs are in your portfolio or not- Yeah. It has a huge impact on your tax efficiency. And I think that goes back to your question, Jake, of, you generally see more REITs out there being small cap, small value, don't you? So that's where you see, really see a- We saw that ratio. That income ratio drop a lot- Yeah. In those asset classes. Yep, that's exactly right. Yeah. Well, maybe comment on this then about- Do you see how he has to be host? He cannot do it. Go Gochnour, go, go. It's so true. That's right, go, man, what do you got? What's your question? Well, the question was gonna be, comparing and contrast then REITs. So some funds have the ability to exclude REITs, right? Others may not, right? Like some of the indexes out there have to own certain things. They may not have the flexibility to think about sort of the tax aspect- Mm-hmm. Of securities like REITs. Right, and the impetus really then becomes on the investor and the advisor thinking about an index is a list of securities, and an index doesn't have to pay taxes. So they don't necessarily have to think about that because it's a paper portfolio, but you don't own a paper portfolio as an investor. So you have to think about, right, sort of look through this and think, what is the impact for me? What is the take home return that I'm gonna realize, right? Because you think about an index, hey look, if you're investing in an index product, you're gonna pay some fees, but then what we're discussing here is, it's not just the fees, it's not just the capital gains about when you're exiting and entering that product, you have a bill coming at the end of the year, and what does that look like, right? That's important. Okay, so high level, here's a couple of things, and we should be really clear. We're not giving tax advice on here, right? These are just kind of logical things you wanna think about with your money, if you're considering how do I ultimately maximize after-tax returns. Right. So high level we're thinking qualified versus sort of non-qualified accounts. Mm-hmm. Correct? Yes. That's where we sort of started the discussion. Yep, that's the beginning of the decision-making tree. That's it. And then when we went over to the taxable side, we said sort of gains, and we said income- Income. Mm-hmm. And the things that we need. I guess the question for me is, as an investor like, what are the questions that I should be asking or what should I be thinking about- Hmm. Or be on the lookout for as we approach this time of year, so that you're not caught off guard with, you're like, "Wow, that's kind of a big tax bill." Yeah. Well, yeah, and so maybe that connects back to kind of the original comments on the estimates. Yeah. So if you go to your financial professional and say, "Hey, what do the estimates look like?" You'll get a breakdown on the capital gains between long-term and short-term. Mm-hmm. And I think most investors are probably pretty familiar with that one. Right. I think the one we wanna highlight here is, as you think about income- Mm-hmm. What you wanna look for is the QDI rate. Mm-hmm. Was that the qualified dividend- Income. Income rate. Yep. I believe it stands for. Yep. And the QDI rate, the goal is always to have 100%, if you can, that means 100% of that income is taxed at that 23.8%. Right. And then as it gets down there, then it drops quite a bit. In fact, let me just give you an example. Yeah. Of what that can sound like. I ran a couple of numbers here. I forgot my numbers, right? In fact I might have to get my glasses- That's okay. For this one. All right, so let's just say you have fund A and fund B, right? And both of them have a pre-tax return of 10%. Now fund A on the dividend income, there is this 100% QDI or 100% of it's taxed at 23.8%. Fund B has a 50% QDI rate, so that means half of that income is taxed is non-qualified- Mm-hmm. With that 40.8%. So if you run the numbers, the tax cost then just on the income, we'll assume there's no capital gains here is 48 basis points or .48% on fund A versus 65 basis points or .65%. So you're talking 17 basis points difference. Yeah. And that is absolute tax savings. Right. That is money in your pocket. Right. To have that lower dividend income. So that's where I comment earlier about, it does get so important. And so, just as an investor, be on the lookout for QDI rates. You can go to any asset manager's website- Mm-hmm. And just search QDI rates or dividend estimates, distribution estimates, I should say, and you can probably get those numbers. That's good. And it's funny on that 17 basis points, that you said .17%, right? Sometimes I talk to people and they're like, "Well, yeah, but that's not a big deal." I'm like, "Yeah, but you're gonna be an investor potentially for the next like 40 years." Yeah. That stuff adds up. It absolutely does, it compounds. And by the way like when we, I'd spend a lot of time talking about funds versus funds, and 17 basis points bridges the gap between a whole range of products. So if you can be more tax-efficient and save some of that, absolutely makes an enormous difference. We're living in 2025 where 17 basis points does matter. People are really thinking about picking up every bit, fighting for every bit where they should be. I love it. Guys, I love the discussion on taxes, and I think for some people when that tax bill comes or get concerned about, it can be a little bit scary. And that's actually gonna lead us into what we're gonna talk about on our next episode. We're in October- Hmm. We got Halloween coming up, and this industry is really good at putting scary headlines out there to freak people out- Yep. About investing- Yeah. So that's gonna be the topic of our next conversation. Mark, would you like to close or do you want me to close? No, you gotta roll with this one. All right. For sure. All right, thanks everybody for taking some time to join us for "The Informed Investor." Scary headlines, we're gonna hit that next, and make sure you hit that button, hit "Subscribe" and tell your friends about "The Informed Investor." We'll see you next time.