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The weeks and months ahead could be a period of great uncertainty for investors with the election, the continued struggle understanding and controlling the pandemic, and the ongoing COVID-related impact on the economy. My conversations with financial advisors in recent weeks have centered on all of these uncertainties, and one topic in particular is coming up: the potential changes in taxation.

It is probable that taxation could look different in the coming years, as my colleagues in the BlackRock Investment Institute have made clear in a recent note. Regardless of who wins the White House and which party controls Congress, it is always important for financial advisors and the clients they serve to manage the tax implications of their investments. The good news is that there are ways investors can do exactly that.

Managing taxes is one of the most important and arguably most overlooked parts of an investment strategy. In my experience, financial advisors and planners generally do an excellent job of managing their clients’ overall tax burdens. For example, municipal bonds are a core part of many clients’ portfolios because of their tax exempt status, and we’ve seen a significant increase in the use of ETFs by advisors to help improve tax control.

But as I’ve seen many times, investors often downplay the tax implications of the investments themselves in their portfolios. In BlackRock’s Investor Pulse survey in 2019, for example, just 8% of investors completely agreed with the statement that taxes are important investment considerations.1

We can and should do better. As we head into an uncertain future with regard to taxes, I emphasize two themes in my conversations with financial advisors.

Taxes can have a major impact on returns

Both mutual funds and ETFs distribute dividend income that tends to be taxable, but the selling of securities by the portfolio managers within the funds can also trigger capital gains taxes that are distributed to investors holding the funds. Here the difference between mutual funds and ETFs can be substantial. Over the past five years, 66% of equity mutual funds paid out a taxable capital gain distribution, while less than 9% of equity ETFs have distributed a taxable gain.2 The effect of those distributions on returns can be significant.

For example, for the 10 years ending in 2019, taxes on distributions reduced returns on the average annual performance of actively managed U.S. Large Cap Blend mutual funds by 1.73 percentage points. Over the same period, the average expense ratio of that category was 0.90%. In other words, while investors are increasingly focused on fund fees — as they should be — the average impact of taxes has been nearly double that of the expense ratio. The fact that the tax bite was larger than the average fees was true over that period in every one of the Morningstar style boxes.3

Big bite: Capital gains distributions mattered more than fund expenses for stock funds in the 10 years ended in 2019

Chart: Big bite: Capital gains distributions mattered more than fund expenses for stock funds in the 10 years ended in 2019

Source: Morningstar (as of Dec- 31, 2019). U.S. style box funds are those funds categorized by Morningstar as US Large Cap Growth / Blend / Value, US Mid Cap Growth / Blend / Value or US Small Cap Growth / Blend/ Value. Data calculated using the oldest share class of all Active US Equity Open-End Mutual Funds available in the U.S. Post-tax returns refer to the average rate of return after the capital gains distributions are subtracted.

ETFs can help

In addition to the typically smaller tax impact of ETFs that results from tracking an index, the structure of ETFs can help limit taxes. For example, a number of features tend to reduce taxes, including the unique creation/redemption process in ETFs which means portfolio managers generally don’t need to liquidate positions to deal with fund withdrawals, as active managers sometimes need to, as well as in-kind transactions, which limits the need to sell securities. Overall, this has resulted in much lower taxes with the ETFs. In 2019, ETFs, accounted for 19% of the $22 trillion in U.S. managed fund assets, but less than 1% of the total capital gains distributions.4

Consider these three strategies to help reduce the impact of taxes

First, in the short term, investors may want to consider tax-loss harvesting — selling investments that are down, the losses of which can be used to offset capital gains taxes.

Second, investors may want to consider selling mutual funds before gains are distributed. Investors should evaluate the tradeoff of paying taxes on the sale of a mutual fund versus paying taxes on the distribution of a capital gain. Financial professionals can utilize BlackRock’s Tax Evaluator Tool as an easy way to track anticipated gains for funds within their clients’ portfolios and the expected dates of distributions.

Finally, it is worth considering whether to take a gain now to avoid the potential of higher taxes in the future. There is no guarantee that taxes will increase in the future, but there are indications that they may, so this course may make sense.

To be sure, “wash sale” rules prevent investors from buying back the “substantially identical” investment within 30 days before and after the date of the sale of the original investment. However, in many cases it may be possible to replace an active mutual fund with an ETF so the investor can stay on track with his or her asset allocation. It is important to note that tax management should be a year-round concern, but the final three months of the year may be the best time to make such decisions. And because tax consequences vary by each individual, investors should consider consulting with a tax professional before making any decisions.

Longer term, it is important for advisors to consider taxes as they build asset allocations for their clients. Although many already do this, many do not.

But even more important is considering which investment vehicle to use. At BlackRock, we believe that active mutual funds can play a valuable role in a portfolio. However, investors should consider whether they have confidence that taxes will not reduce or eliminate any potential returns, particularly in asset classes and funds with higher turnover. Using cost- and tax-efficient ETFs — either as core or satellite exposures — can help improve after-tax returns and demonstrate that advisors are adding value to their clients.

Michael Lane

Michael Lane

Head of iShares U.S. Wealth Advisory at BlackRock