How To Use ETFs To Reduce The Tax Bite In Your Portfolio

Now that the 2014 tax season is in the rear view mirror, it is a perfect time to start analyzing and strategizing your game plan for 2015. With two-thirds of the year still to go, there are a number of smart moves you can make to reduce the impact of future taxes that will have to be paid on any non-retirement accounts.

One of the easiest ways to do that is by reviewing your exiting positions and trading history to determine if there are reasonable adjustments or substitutions that can be made. Often legacy mutual funds, inefficient income assets, or over trading within a taxable account can create a significant tax burden. Fortunately, there are a variety of ways you can enhance your tax efficiency using exchange-traded funds.

Reducing Impact Of Capital Gains

ETFs make excellent long-term holding vehicles because the majority of them track a passive index. This creates very little real-world turnover of the underlying holdings, which in turn generates very few if any capital gains.

This can be a significant benefit over traditional actively managed mutual funds with high turnover rates that generate annual capital gains taxes. The pooled investment structure dictates that capital gains are passed through to shareholders in proportional amounts. Short term capital gains are taxed at ordinary income rates, while long-term gains are typically capped at 20% (or less) for most taxpayers.

Qualified vs. Non-Qualified Income

Another way to reduce the tax impact of your non-retirement assets is to seek out qualified dividends, which are taxed at a maximum rate of 15%. These are generally dividends that are paid from a domestic corporation and certain qualified foreign corporations. Additional explanation and rules on qualified versus non-qualified dividends can be found here.

The Vanguard High Dividend Yield ETF (VYM) invests in a basket of well-known dividend paying stocks such as Exxon Mobil Corp (XOM) and Microsoft Corp (MSFT). The current yield of VYM is 3.03% and quarterly distributions are considered qualified based on the underlying makeup of the companies in this ETF.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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