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Taxes are inevitable when it comes to investing. Uncle Sam has to have his share. And it looks like he may be getting a bit more going forward. Thanks to the big recent spending packages designed to fight the COVID-19 pandemic as well as additional plans on the docket, the Biden Administration and Congressional Democrats are looking at several proposals to pay for that spending.
Higher taxes could be on the way.
But don’t count Wall Street out yet. One big beneficiary of Biden’s tax plans could be active exchange traded funds (ETFs). As a tax-efficient investment vehicle, active ETFs are better suited to deal with the potential changes to taxes. Already, we’ve seen investors move in this direction. If these plans come to fruition, active ETF issuance and demand could surge.
See our Active ETFs Channel to learn more about this investment vehicle and its suitability for your portfolio.
While you can debate whether or not we should have spent the money, the reality is, the U.S. government spent a lot to get out of the pandemic. The CARES Act in 2020 was nearly $2.2 trillion, and the COVID-19 Rescue Package earlier this year was nearly $1.9 trillion. And the spending has continued. The recent bipartisan infrastructure package was another $1 trillion and House Democrats have unveiled another social spending bill for debate to the tune of $3.5 trillion.
All in all, that’s a lot of cash. And paying for that is going to come from a variety of sources, especially higher taxes.
The proposals from the Biden Administration and Democrats include increasing the corporate tax rate from 21% to 26%. Additionally, the marginal income tax rate for individuals earning over $400,000 would increase from 37% to 39.6%. A proposal of an additional 3% surcharge on income above $5 million for a married household, or $2.5 million for an individual filer, is also in the works.
This is where it gets interesting for investors. Under the current plans, President Biden is looking to raise the top marginal tax rate on long-term capital gains from 20% to 25%. Additionally, dividends are in the same cross-hairs and will see their marginal rates increase. A new tax on buybacks has also been discussed.
And even without President Biden, higher taxes may be coming. While the Tax Cuts and Jobs Act of 2017 did lower capital gains income thresholds, it also includes an inflation clause that changes the numbers due to inflation. With the CPI/PPI running very high, we should see that clause trigger and we may all be facing higher capital gains regardless of any additional proposals.
It’s no wonder investors have taken a shine to active ETFs this year.
Passive ETFs have long been a tax-efficient vehicle for investors. The reason is in their structure. ETFs have something called a creation/redemption mechanism. This allows managers to deal with inflows/outflows from authorized participants (APs) by creating or redeeming ‘creation units.’ Basically, when an AP wants to cash out, they get an in-kind delivery of the ETF’s underlying holdings. If an AP cashes in shares of SPDR S&P 500 ETF (SPY), they get all the stocks in the index in their hands.
Mutual funds, on the other hand, can’t do this. Managers of mutual funds must rebalance their holdings by buying and selling securities to manage shareholder redemptions or to re-allocate assets. This is even true for broad index funds. When a manager sells stocks or bonds within their portfolio, it generates capital gains, which must be distributed to shareholders at the end of the year. And investors will pay taxes on those gains whether or not they sold any shares of the fund.
The difference is striking. According to a new paper by authors at Villanova and Lehigh universities, ETFs have exhibited an average tax burden that was 0.92% lower than active mutual funds over the last five years.
The best part is that active ETFs now get to play by the same rules as passive ones. The Securities and Exchange Commission Rule 6c-11 provides that active managers use optimized, custom or negotiated in-kind baskets for ETF creations and redemptions. This allows fund managers to still provide similar tax benefits as passive ETFs while still having their ‘secret sauce’ hidden like regular mutual funds do. This explains why there have been so many copycat ETF launches in recent months.
Check out this article to see how active ETFs could be better than their mutual fund twins.
Now, there is one major caveat to all of this. Senate Finance Committee Chairman and Oregon Sen. Ron Wyden submitted a series of proposals that would end or tax the ‘in-kind’ benefit for ETFs. As such, the tax efficiency of the fund structure would cease to exist and they would be no better than mutual funds. However, like all the proposals, Wyden’s moves are not concrete yet.
For investors, the potential for higher tax proposals on investments and capital gains means we need to do some tax planning now. Getting ahead of any potential changes could be beneficial. While Wyden’s plan is a wild card, some tax hikes are likely in the year ahead.
The key is to lock in lower capital gains taxes now before any sort of rate hike goes into effect. Simply selling long held shares in a mutual fund and replacing it with a similar active ETF might make sense. In some cases, like with the T. Rowe Price Dividend Growth ETF (TDVG) and T. Rowe Price Dividend Growth Mutual Fund (PRDGX), you’re getting the same manager, fund focus, and holdings, just at a lower expense and tax cost ratio.
With the potential for higher taxes, this is a major win for investors and the growth of active ETFs.
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