Assess tax drag and performance?

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Assess tax drag and performance?

Postby Vision6800 » Mon Mar 20, 2017 11:08 am

I'm in need of clarity. Am thinking of going with an actively managed fund (in a taxable account) with high turnover but don't understand the tax implications.

Annually I'll be responsible for taxes on the distributions from the fund, and I'll pay taxes when I sell the fund.
If the fund generates x annual distributions, isn't it as easy as reinvesting say 85% of x back into the fund and keeping the balance to pay the annual taxes with? Or reinvesting it all and selling shares when it's tax time? This seems fine, am I missing something?

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House Blend
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Re: Assess tax drag and performance?

Postby House Blend » Mon Mar 20, 2017 2:37 pm

Probably not a good idea. Best to put active funds in tax-advantaged or don't use them at all. (There may be some low-cost active funds that rarely distribute gains, but I'm doubting that that's what you are looking at.)

In practice, I think most people in accumulation mode would reinvest 100% of the distributions (not necessarily back into the same fund) and pay the additional income tax out of cash flow. If cash flow is not sufficient, then don't auto-reinvest and hold enough back to pay the tax. Auto-reinvesting and then selling shares is worse.

As to why this is not a good idea: Annual tax leakage is just as toxic as a higher ER. For example, if your fund distributes 2% in qualified dividends and 2% in LT cap gains every year, and you pay 15% tax on LTCG, it's like your taxable shares are in a special share class whose ER is 0.60% higher than if the fund were in tax-advantaged.

And the leakage is worse if:
--it also distributes short term gains, or
--you also have to pay state taxes, or
--more of your dividends are non-qualified (e.g., due to the higher turnover).

To take a random but popular actively managed fund, consider Vanguard Health Care (VGHAX): ER 0.31%. Last year, it distributed about 1% in (qualified) dividends, 0.3% in ST gains, and 4.5% in LT gains.

If you pay 5% state tax, 25% Fed on ordinary income, and 15% on LTCG, that's an annualized tax cost of about 1.2%. Would you still invest in VGHAX if it had an ER of 1.5%?

With a fund like 500 index (VFIAX), the additional tax cost under the same tax rate assumptions would have been about 0.4%.

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