Choose the Appropriate Investment Vehicle – Part 3

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There is an art to selecting the right investment vehicles for individual portfolios. Different types of advisors are prone to recommend different financial vehicles. You need to make certain that your best interests are served to best reach your financial objectives.

Investors’ needs vary by the size and type of their portfolio. Taxable, Retirement, and Roth accounts all thrive using different investment vehicles.

Expense ratios, transaction costs, and diversification are three of the five factors that should be considered when matching an investment vehicle to a given account. This week, we will look at the final two and apply these principles to a variety of accounts.

Capital Gains

When you sell an appreciated stock in a taxable account you must pay capital gains tax (currently 15%) on the appreciation. With individual stocks, you can decide how long to hold the stock and therefore control when you trigger having to pay capital gains tax. With mutual funds, the fund manager decides what stocks the fund is buying and selling. So each year, the mutual fund company determines the amount of capital gains tax shareholders must pay.

Another problem with mutual funds is that you don’t pay capital gains tax based on how much the fund has appreciated while you have owned it, you pay capital gains tax on how much capital gain was realized while you owned it. This has led to some shareholder frustration.

During 2000, for example, some shareholders bought a mutual fund that declined sharply and also sold positions that had been held for many years. These positions realized several years of capital gains for their shareholders. Needless to say, investors who experienced a sharp decline of principle and also a large capital gains tax in the same year of investing were not happy. This is called “phantom income” – income realized on paper but not in your wallet. Regretfully, since it’s income, it’s taxable.

Morningstar publishes the percentage of capital gains that each fund is sitting on. This is important only if you are investing a taxable account where the dividends from capital gains are taxable. So mutual funds that have a high capital gains exposure should be purchased in retirement accounts, not taxable accounts.

Exchange-traded funds offer the best of both worlds. While they have the diversification of mutual funds, instead of buying and selling stocks, they exchange the stock they are selling for the stock they are buying. Since the exchange is a “like-kind” exchange, it does not trigger capital gains tax until you decide to sell the exchange-traded fund itself.

Turnover

Turnover is the percentage of investments that are bought or sold each year. If half of a portfolio is bought and sold in a year, the turnover ratio is 50%. If the entire portfolio is bought and sold every six months, then the turnover ratio would be 200%. Whenever an investment is sold for a profit, capital gains taxes must be paid in taxable accounts.

Likewise, if an investment in a taxable account is sold for a loss, you can take that loss off on your taxes. Individual stocks allow you to sell your losers and keep or give your winners – a smart tax strategy. In a large taxable account, that is better than a mutual fund that does not allow you to separate the two.

Application

Given these five factors to consider for investment vehicles, different accounts should use different types of investments. A taxable account with millions of dollars can be diversified with individual stocks and bonds. This offers an expense ratio that approaches zero and the opportunity to sell stocks with losses and give or keep stocks with gains for additional tax savings.

A retirement account with amounts under $50,000 may be better put in mutual funds with no load and no transaction costs. Since the account is a retirement account, any capital gains positions that the fund is sitting on do not matter. Although the expense ratios may be slightly higher, the fact that there are no transaction costs associated with buying or selling makes mutual funds a preferable investment in smaller accounts.

In the middle, exchange-traded funds may offer a way to diversify portfolios under a million dollars and still keep the expense ratios as low as possible.

Photo by chuttersnap on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)