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4 ETFs For Those Seeking Greater Tax Freedom

Here's how to help take a bite of the tax burden

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A leading non-partisan tax policy researcher, The Tax Foundation, estimates that your first 111 days belong to the U.S. government. When the estimate includes the effect of federal borrowing, the date moves to May 6. In other words, you work for Uncle Sam in your first 125 days of a given year, while the remaining 240 belong to you.

The effect of federal borrowing cannot be understated. Right now, you work an extra 14 days to pay the interest on the country’s debt. On the other hand, the Federal Reserve’s zero-interest-rate policy coupled with quantitative easing (”QE”) has kept the borrowing costs for the U.S. exceptionally low.

If rates returned to “normal,” the current 6.4% of tax dollars going toward interest on sovereign debt would likely jump to 12.5%. Instead of working until May 6 to reach “Tax Freedom Day,” you may need to wait until June approaches.

Keep in mind, I haven’t mentioned the probability that tax rates for families are likely to climb. Consider Congressional Budget Office (CBO) data that shows the trend of an increasing burden on the top 20% earners, not just the much-maligned 1%. The Wall Street Journal, citing the CBO data, explained that increased taxation of a couple with two children making more than $150,000 has jumped from 65% in 1980 to more than 90% by 2010.

Think increases in taxes will only hit the top 20% of income earning families? Then you must not be paying attention. Due to a lack of savings by “Boomers” and “Gen Xers,” as well as an increasingly aging population and new entitlements, the U.S. will need to collect as much as 25% more tax revenue above the average percentage (17.4%) of gross domestic product (GDP). Yet half of Americans effectively contribute zero dollars to the present tax system. Indeed, one does not need to be psychic to foresee the onerous tax hikes ahead.

Granted, there are scores of legitimate ways to reduce a tax albatross. One family might look to shift some W-2 earnings to 1099 income such that the side business activity offers deductible expenses. Another family might move from a high-tax state to a lower-tax state. Still, are there ways that a market-based investor can reduce the number of days that Uncle Sam has commandeered?

The short answer is, “Yes.”

Unfortunately, most people’s imagination rarely moves beyond tax deferral in an employer-sponsored plan. Tax deferral is remarkably beneficial in compounding the growth of a portfolio. On the other hand, pushing one’s tax obligation out into the future is not the same as shrinking it or eliminating it.

Enter the exchange-traded index fund. An ETF that tracks an established index does not distribute significant capital gains the way a traditional mutual fund might. For one thing, an index does not change very much, if at all. Without the need to change what the ETF holds, the lack of trading activity means there are less distributions to shareholders for tax consequences. Similarly, outflows force the sale of securities in mutual funds; the redemption process for an ETF is different than the process for a mutual fund whereby the ETF structure enhances tax efficiency.

According to a 2012 study at Morningstar, the 5-year average distribution for a large-cap stock blend mutual fund was nearly 2%. ETFs? 0%. For one who might have $200,000 in large stock mutual fund exposure, that’d be four thousand dollars in capital gains distributions annually. Five years of holding the large cap fund would cost $600 per year at a 15% capital gains rate for a total of $3000. Simply selecting iShares S&P 500 (IVV) in one’s brokerage account would eliminate the levy.

Article printed from InvestorPlace Media,

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