UNDERSTANDING THE TAX EFFICIENCY OF ETFs

Investors may know that exchange traded funds (ETFs) can be a low cost and transparent investing option, but many overlook another key benefit: tax-efficiency. iShares ETFs can help simplify investing and may allow investors keep more of what they earn.

LEARN MORE ABOUT HOW TO MANAGE YOUR TAXES

The following 3 potential benefits may help you get handle on that year end tax bill.

1

Offset taxes

Through tax loss harvesting

2

Seek to minimize tax obligations

By maximizing tax sheltered accounts

3

Insulate yourself from the actions of others

With tax-efficient ETFs

WHAT YOU SHOULD KNOW ABOUT TAX LOSS HARVESTING

Tax loss harvesting is the act of selling an investment below its purchase price to realize a loss in a taxable account.

While current market volatility may get your portfolio down, consider tax loss harvesting to aim to unlock potential tax benefits.

Video 2:41

WAKE UP AND SMELL THE COFFEE (& TAXES)

Armando Senra, Head of Americas ETF and Index Business at BlackRock, and Daniel Prince, CFA, U.S. Head of iShares Product Consulting, discuss ways to potentially reposition your portfolio to help take advantage of tax loss harvesting opportunities while also staying invested.

Armando Senra: 
Okay.

 

Danny Prince:
Okay, Armando. Let's talk tax.

 

Armando Senra:
Right, so, Danny. We are in 2022. Obviously very difficult market environment, but we are saying that volatility also brings opportunity. Why don't you tell us a little bit more about it?

 

Danny Prince: 
Yeah, Armando, look, it's tough to control markets, but this is an environment where investors may want to consider controlling taxes. And by that, I mean taking advantage of tax loss harvesting opportunities, which is essentially banking a loss today to offset current or future taxes. And really, this is relevant to most investors today, all the way from the most conservative, to the most aggressive.

 

Armando Senra:
Got it. So you are in this environment where 70 percent of stocks in the market are down for the year. You also have an environment where bonds have the biggest drawdown since the 1980s. So this is the perfect opportunity for investors to do this, right?

 

Danny Prince:
That's right. This opportunity is critical in this moment. And when you think about the opportunity, Armando, single stocks, single bonds, I think about mutual funds, ETFs. The key here is that investors may want to consider staying invested while taking these losses and navigating the wash-sale rule, so that you can effectively create value in a market that's hard to find. And what we're really telling investors, harvest the losses, stay invested, and this is the opportunity to either rethink or redesign your portfolio going forward.

 

Armando Senra:
Right, Danny. So what we are saying is, one of the things that investors can consider is, you take your individual stock where you had a loss, you harvest that loss, and you buy an ETF that gives you a diversified exposure. For instance, in the same sector of the market. And you can do the same thing with fixed income ETFs and losses that you want to capture from bonds. So the other benefit is through iShares ETFs, investors stay invested in this very difficult market environment.

 

Danny Prince:
Yeah, that's right. Armando, the opportunity is abound out there. And really, there's a lot for investors to think about. One thing that I'm thinking about, have you had your second cup of coffee yet?

 

Armando Senra:
Danny, this is the second cup already.

 

Danny Prince:
Always one cup ahead of the game. (laughs)

 

Voice:
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SEEK TO MINIMIZE TAX OBLIGATIONS

Max out your 401K, IRA, and other tax advantaged accounts

When investing for retirement, it’s critical to stay focused on what really matters — after-tax returns. In other words, don’t let taxes take a backseat to other key considerations such as costs and risk.

Taxes can be a big drag on your long-term returns: in 2021, the tax costs of the average active U.S. equity mutual fund were more than double the expense ratio.2 Even a seemingly small tax rate of 2% would cost a hypothetical $100,000 portfolio over $45,000 after a decade of 10% average annual returns.3

A potential way to generate after-tax returns is to maximize your savings in tax-advantaged accounts. Remember, it’s not what you make, it’s what you keep, so talk to your financial advisor about (re)positioning your portfolio for after-tax returns.

FAQs ABOUT TAX SHELTERED ACCOUNTS

  

A 401(k) plan is an investment account offered by employers that allows you to save for retirement. If your company offers a 401(k) plan, it will have certain eligibility requirements. Eligibility requirements vary by firm, as does whether and how a company contributes to its employees’ 401(k) plans.

There are two common types of 401(k) plans: Traditional and Roth. Both types of 401(k) plans are subject to the same annual contribution limit, which is $20,500 for 2022 and $22,500 for 2023. If the plan administrator allows, participants aged 50 or older can also make additional catch-up contributions of up to $6,500 for 2022 and $7,500 for 2023. (Other types of 401(k) plans include the SIMPLE 401(k) plan, which is designed for small businesses with 100 or fewer employees who receive at least $5,000 in annual compensation.)

Contributions to traditional 401(k) plans are typically made before taxes, while withdrawals are subject to income tax. This structure helps individuals lower the amount of income subject to taxes in the present and then withdraw funds.

When it’s time to start using your traditional 401(k) plan savings, be sure to consider the tax implications. With a 401(k), you can typically start to take penalty-free withdrawals when you turn 59 ½. But if you need the funds before then, you could incur an additional 10% early withdrawal tax penalty — on top of what you’d normally pay in state and federal taxes — unless an exception applies.

Roth 401(k) plans work differently from traditional plans: Contributions are made after taxes, while withdrawals are tax free. Because you’ve already paid taxes on you’re savings, withdrawals won’t be taxed as long as you meet both of the following criteria:

  1. You’ve had the account for at least five years.
  2. You begin to make withdrawals either after you’ve turned 59½ or due to disability.4

Another big difference between traditional and Roth 401(k) plans centers around whether the IRS mandates withdrawals from the plan. Most Americans are required to start taking distributions from traditional 401(k) after they reach age 72, while there are no age-related withdrawal requirements for Roth 401(k) plans.

An Individual Retirement Account, commonly known as an IRA, is designed to help individuals save for retirement. As with 401(k) plans, there are two common types of IRAs: Traditional and Roth. (Another type of IRA is a Simplified Employee Pension plan, or SEP, where an employer makes direct contributions for each employee.)

traditional IRA is a retirement account in which individuals can make pre-tax contributions.

You can start to withdraw your savings penalty-free when you reach age 59 ½. Taking out your savings before that time could cost you an extra 10% on top of what you’d normally pay in state and federal taxes.

Once you turn 72, you typically have to withdraw a minimum amount annually to comply with distribution requirements. The exception is Roth IRAs, which never force you to take withdrawals.

403(b) plan: Similar to a 401(k) plan in its structure and function. While 401(k) plans are used by employees of for-profit companies, the 403(b) is designed for employees of non-profits and government organizations such as public schools.5

529 plan: Designed to help Americans save for and pay the cost of higher education. Withdrawals from 529 plans are tax free provided the funds are used for so-called “qualified” education expenses, including tuition, books, and room and board at accredited institutions. Contributions into 529 plans are made on an after-tax basis; the maximum annual contribution to an individual 529 plan is $80,000, or $160,000 for a married couple. These limits are based on contributions prior to triggering a gift tax.

Health Savings Account (HSA): Allows individuals to set aside pre-tax dollars to use for health-related expenses. HSAs are only available to people with a high deductible health plan, with a minimum deductible of $1400 for individuals and $2800 for families in 2022. Those who qualify for HSAs in 2022 can contribute up to $3650 for an individual or $7300 for a family. A portion of the HSA can be invested in a variety of financial instruments and the gains from interest or price appreciation are not taxable.6

Flexible Spending Account (FSA): An employee-sponsored plan similar to an HSA. An FSA allows people to use pre-tax dollars — up to $2750 per year — to pay for health-related expenses. A major difference is that FSAs have an annual “use it or lose it” feature: A maximum of $500 in FSAs can be carried over from one plan year to another, while there’s no rollover limit on HSA funds.7

WHY AND HOW ARE ETFs TAX EFFICENT

Exchange-traded funds (ETFs) are generally designed to be tax efficient, helping investors keep more of what they earn. ETFs held 24% of U.S. managed fund assets in 2021 yet were responsible for less-than 1% of capital gains distributions.8

Most ETFs are index funds, which generally trade less than their actively managed counterparts. This “low turnover” means index ETFs typically have to sell holdings that have appreciated in value less often, which helps to avoid triggering realized capital gains.

ETFs trade on exchanges, just like stocks. As a result, ETF managers don’t have to sell holdings. With an ETF, you control if and when you sell and are never taxed as a result of actions by other shareholders.

Chart displaying hypothetical growth of $100k over 10 years at 15% return

DON'T BANK ON PRE-TAX RETURNS

Taxes can make a significant impact on return and, in many cases, can be just as important as other factors in your investment decision. For example, on a $100,000 investment over a 10 year period, the impact of taxes could be in the tens of thousands.

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