Time is running out for a set of money-saving provisions in the tax code, and now is a good time to get your portfolio in order and minimize levies, according to Bank of America. The Tax Cuts and Jobs Act (TCJA), which took effect in the beginning of 2018, overhauled the federal tax code. It roughly doubled the standard deduction, adjusted individual income tax brackets, lowered most of the rates and applied a $10,000 cap on the state and local tax deduction. Unless Congress acts, a slate of provisions in the legislation will sunset at the end of 2025, which could rattle taxpayers. TCJA expiration may mark the largest tax increase in history, worth $4.6 trillion, wrote Jared Woodard, investment and ETF strategist at Bank of America, noting that the aggregate tax burden on U.S. households would rise by $2 trillion in the next five years. In some estimates, the top fifth of households could pay 2-6% more of their income in taxes, he added.
With that backdrop, Woodard gave investors a few steps to help prepare their portfolios for the higher tax climate. Stick with tax-efficient ETFs. In general, exchange traded funds are more tax efficient than their mutual fund counterparts. Mutual funds tend to have higher turnover – that is, buying and selling of underlying securities – and by law they must distribute capital gains. Investors in mutual funds don’t have to sell shares to be subject to taxable capital gains: A fund manager who sells some holdings to take profits or to cash out investors who are leaving, for instance, incurs capital gains and they need to be distributed to shareholders. For the same investment, taxable events mean mutual funds cost investors 1.3% per year vs. just 0.4% for ETFs, said Woodard. He added that an investor who plugged $100,000 into an S & P 500 ETF in October 2013 and held on through today would have wound up with $359,000. That compares with a balance of $316,000 if it were an S & P 500 mutual fund.
Think dividend-paying stocks vs. bonds. Stocks that spin off qualified dividend income could also be tax-friendly for investors keeping them in a brokerage account. Qualified dividends are subject to a tax rate of 0%, 15% or 20%, depending on the investor’s taxable income. Interest income from bonds, on the other hand, is generally taxed at the same rate as ordinary income – which can be as high as 37%. Be aware that this treatment is different for municipal bonds, which are tax free on a federal basis and could be exempt from state levies if the investor resides in the issuing state. Meanwhile, income from Treasurys are subject to federal income tax, but exempt from state and local tax. Investors should bear in mind that tax considerations are just one of the factors to weigh in their portfolios. That is, the tax-friendly aspect of dividends shouldn’t spur you to snap up stocks if your risk appetite and goals suggest bonds would be a better choice.
Seek tax-efficient opportunities for your holdings. Take a look at your portfolio and see whether there are opportunities for tax-advantaged yield, Woodard said. Many ETFs take advantage of qualified dividend income and return of capital for tax efficient distribution, he wrote. For investors seeking income, the strategist called out high yield municipal bonds, which offer 6-7% tax-adjusted yields basis, 350 bps more than the U.S. aggregate bond index. Funds he spotlighted include the SPDR Nuveen Bloomberg High Yield Municipal Bond ETF (HYMB), which has an expense ratio of 0.35% and a 30-day SEC yield of 4.32%. The VanEck High Yield Muni ETF (HYD) has an expense ratio of 0.32% and a 30-day SEC yield of 4.16%. Woodard also called out master limited partnerships. These instruments trade like stocks, but benefit from their partnership structure, because their income distributions aren’t subject to corporate taxes. That results in higher yields. For ETF plays, the strategist highlighted Global X MLP & Energy Infrastructure ETF (MLPX) and the Global X MLP ETF (MLPA). Both offerings have expense ratios of 0.45%. MLPX boasts a year-to-date total return of roughly 34%, while MLPA has a total return of more than 14%.