For a non-retirement account, a common misconception with investments is that you only pay taxes when you sell your shares. This is normally true when you own an individual stock of a company that didn’t issue a profit-sharing dividend while you held it. However, very few investors own and trade individual stocks. The vast majority of people pool their assets together with thousands, if not millions, of other people to have a professional management team invest those funds into a large collection of different stocks and bonds called mutual funds or exchange-traded funds (ETFs).
While there’s no real issue with professional management—it frees up time for the investor to be less hands-on, removes emotional biases over a single stock, helps build a diversified portfolio, and is managed by an expert (or at least we all hope it is)—the trade-off for this form of investment management is rarely discussed: the taxable impact a mutual fund can create in a non-tax-deferred account or a non-retirement account.
Think of a regular bank account, brokerage account, or trust account. These types of accounts are immediately accessible, meaning they don’t have a barrier to access like waiting until the appointed retirement age to access the funds penalty-free. They are subject to the capital gains rules for the United States tax code. With freedom comes a cost: the IRS wants its dues in the form of short- or long-term capital gains.
Short-term gains generally mean you held the asset for less than a year, and long-term gains mean you held it for more than a year. This applies whether you made money (a gain) or lost money (a loss). The simplest method to avoid the tax is to simply not sell until you need the money or have a taxable loss to offset the taxable gain. However, when invested in a mutual fund or ETF, the individual investor does not always have the choice of when those taxes arise.
This last point often causes a stir among investors as they believe they control when they buy and sell the mutual fund. While it’s true that investors can pick and choose when their money goes into the pool and when they need the money back, everyone else they are invested with can do the same.
To understand this better, imagine two investors: Steve and Greg. Steve is a diligent investor who understands that funds are meant for the long term and rides the waves of volatility with a smile. Greg, on the other hand, hates volatility and sells everything the second he sees negative values in his account. If Steve and Greg are invested in the same mutual fund, it can cause an issue for Steve even though he did not sell his shares.
A mutual fund is invested in the stock market or bonds, depending on its strategy. All who are invested in the same fund are invested in the same strategy. Since the pool of assets is typically invested in appreciating assets, the fund company does not have the cash on hand to pay back all the withdrawal requests. To raise the funds, the fund company sells shares within the fund and sends the money back to the investor. Depending on what they sell, whether it is for a loss or a gain, those values pass proportionately through to the investor and their individual tax situation.
If you haven’t pieced it together yet, don’t worry, most people don’t. Since the fund is a pool of ownership, even though Steve didn’t sell any of his shares, liquidations were still made within the fund he owns. If those shares were sold for a gain, Steve is now faced with a potential tax bill. Even though he weathered the storm, he feels the brunt of others’ decisions because he is pooled together with multiple investors.
The Solution: Direct Indexing Through Separately Managed Accounts (SMAs)
The way to avoid this inefficiency is to follow a growing concept called direct indexing through Separately Managed Accounts (SMAs). SMAs operate under the same basic principle as a mutual fund or ETF in that they provide a diversified portfolio of stocks. However, the major exception is that an investor in an SMA is the only investor, making it very tax-efficient. This eliminates the inefficiency that a pool of investors can cause in a non-retirement account and provides other tax benefits (which will be covered in another article).
SMAs are offered through most of the largest brokerages like Charles Schwab, Fidelity Investments, or BlackRock. Each will have different minimum investment requirements, management fees, and performance metrics, so it’s always best to do your research to find what fits you best.
By understanding the hidden tax implications of mutual funds and exploring alternatives like SMAs, you can make more informed investment decisions and potentially save on taxes.