Trending
That headline isn't intended to be politically charged, but as advisors well know, we live in highly partisan times and there's a better chance that trend will continue than it will end anytime soon.
Something else advisors are getting acquainted with these days is tax talk. To fund his $3.5 trillion spending package, President Biden is pitching the most significant tax hikes seen in several decades. Those include elevated corporate taxes and higher levies for on income and capital gains taxes for wealthy folks – individuals making $400,000+ per year and married couples making $450,000+.
Obviously, there's considerable debate surrounding these proposals and it will likely be awhile before Congress takes these ideas up. However, there mere specter of higher taxes likely explains why advisors are fielding more inquiries regarding tax-advantage asset classes.
Clients, however, are likely losing sight of or aren't even aware of another tax proposal – one that involves potentially stripping exchange traded funds of a tax benefit the asset class has enjoyed for decades and one that contributes mightily to ETFs' ongoing pilfering of assets from active mutual funds.
Here's the long and the short of it. Legislation recently introduced by Senate Finance Committee Chairman Ron Wyden (D-OR) seeks to bring ETF taxation more inline with what that of mutual funds. In plain English, the proposal, which is buried among others in a broader package and not explicitly highlighted by Wyden, would, if it's signed into law, subject ETF investors to paying capital gains taxes.
“The effort would address an advantage for ETFs that stems from a law dating back to the Nixon administration. The law exempts so-called regulated investment companies, or RICs, from recognizing a taxable gain on assets if shareholders are paid out 'in kind.' In other words, if withdrawing investors are paid in securities like stocks rather than in cash,” reports Bloomberg.
Not the Worst Idea, But...
Advisors and their increasingly savvy clientele know that the lack of capital gains levies associated with ETFs are an obvious plus. On personal note, I've been covering the industry for 14 years and it seems like every December, ETF issuers of all sizes send out press releases touting the fact that few, if any, of their funds will be distributing capital gains for the year.
On the other hand, investors involved with actively managed mutual funds are all too familiar with picking up the tax tab when the fund manager sells a winning position. Fortunately, for advisors (and clients) that are embracing ETFs, this tax situation is on the up and up, legally speaking.
“However, because of a technicality, ETFs shareholders pay lower capital gains taxes. The 1940 Act mandates that funds distribute substantially all their annual net realized capital gains, thereby creating a taxable event for shareholders,” says Morningstar's John Rekenthaler. “So far, so fair. But because mutual funds must sometimes sell their portfolio holdings to raise cash for investors who redeem their shares, while ETFs can avoid doing so by using 'creation units', mutual funds tend to generate higher tax bills.”
Cutting through all the political mumbo jumbo, essentially what Sen. Wyden is aiming to do is make ETF issuers and thereby investors face the same tax treatment as mutual funds.
As Rekenthaler notes, there's a better way: Eliminate the regulatory difference between ETFs and mutual funds, allowing active mutual funds to take part in the tax benefits accruing to ETFs.
“Rather than make ETF investors pay more capital gains taxes, Congress should permit mutual fund shareholders to pay fewer--or more precisely, none. Neither mutual funds nor ETFs should distribute their realized capital gains. Instead, those monies should remain with the fund until the shareholder sells,” he adds.
Dicey Outlook
As it stands today, Wyden's ETF-related proposal would generate just $205 billion in receipts over a decade, according to initial estimates from the Joint Committee on Taxation. In Uncle Sam speak, $205 billion is practically nothing.
Add to that, we're getting close to 2022 – a mid-term election year – and armed with ample cash and cadres of lobbyists, ETF issuers are going to fight this proposal. That's a given.
That could put politicians supporting the ETF tax pitch in a tough spot. They can continue backing a flawed idea and risk drawing the ire of constituents that are investors and donors or they can consider bestowing tax benefits on mutual funds.
In either scenario, additions to the tax code must be made – something that only accountants enjoy. Perhaps it's best politicians just leave well enough alone on the ETF tax front. Advisors and clients can only hope that's what the outcome will be.