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The good, the bad, and the tax efficient

Tax time is here again—the time to think through how your income, deductions, contributions, and investments all add up. We know taxes are inevitable, but ETFs can help minimize how much you pay on your investments.

There’s one thing that we can all agree on: no one loves paying taxes, and we’d all love to pay less.

When it comes to your investments, not all taxes are the same. Being liable for some types of taxes is better than being on the hook for others.

Is there such a thing as “good” taxes? While paying taxes never feels good, the blow is softened when they’re levied on a cash return on your investments—for example, the investment income from dividends, or the gain from selling a security whose price has appreciated over time. These are cash flows that can be reinvested and allowed to compound, or used to help meet expenses.

“Bad” taxes, on the other hand, have no corresponding cash return for investors. These are taxes incurred when the manager of a fund sells securities within the portfolio at a profit. For example, if a manager buys shares of stock in a portfolio and later sells them at a higher price, the profit must be distributed to shareholders as a capital gain. And, as a shareholder, you’ll owe taxes on that distribution, even if the fund itself has an overall loss.

The idea is to keep as much money working in your portfolio as possible. — Martin Small, Head of U.S. iShares

“The idea is to keep as much money working in your portfolio as possible,” says Martin Small, head of U.S. iShares. “ETFs help do this by reducing ‘phantom’ taxes from balance sheet distributions, letting investors focus on taxes that come from beneficial sources such as dividends and realized gains.”

Tax awareness is integral to the iShares portfolio management process, which is why iShares ETFs tend to trigger fewer capital gains distributions. Since they are more tax-efficient, iShares ETFs can help you minimize “bad” taxes.

Over the long term, these saving can add up: in the example below, the combined effect of capital gains and dividend taxes take an increasingly big bite over time, costing more than $5,000 in 5 years.

Bite back at taxes: small differences can have a big result

$100,000 example (hypothetical 4% return per year with 1% tax cost)

Chart: Bite back at your taxes: hold on to more of your earnings

Source: BlackRock. For illustrative purposes only. This is not a guarantee of any future result of experience. This information should not be relied upon as tax or investment advice, or a recommendation regarding the iShares Funds or any security in particular.

ETFs also tend to be more tax-efficient than actively managed mutual funds. Here’s why: since active funds aim to beat a market index, they usually engage in a lot more buying and selling than ETFs, which are designed to track an index. As a result, active mutual funds will likely trigger more capital gains distributions—and higher taxes. And unlike ETFs, which are traded directly between investors on an exchange, individual shares in a mutual fund are tied to other investors in the fund. When your fellow mutual fund shareholders redeem their holdings, you might unexpectedly end up footing the tax bill too.

Not all ETFs providers reduce investor tax exposure

% of funds that paid capital gain distributions over the last 5 years

Chart: Percentage of funds that paid a capital gain distributions over the last 5 years

Morningstar, as of 12/31/17. Average number of mutual funds that paid a capital gain distribution each year over 5 years. Universe includes all U.S. open-ended mutual funds, oldest share class used. Universe includes all funds incepted before 10/31 in each year and excludes funds that closed before 10/31 in each year. Past distributions are not indicative of future distributions.

Are all ETFs providers as equally effective at reducing investor tax exposure? Over the last 5 years, 57% of mutual funds paid out a capital gain distribution, versus 9% of non-iShares ETFs. That’s a notable distinction. But by comparison, just 5% of iShares ETFs made capital gains distributions on average, meaning they have performed tax efficiently and cost effectively.

No one loves talking about or paying taxes. But there’s no better feeling than knowing you’ve taken steps to minimize the impact of taxes on your investments.

Want to see what a portfolio using tax-efficient iShares ETFs could look like? Try our Core Builder tool for a personalized example.