In Capital Gains 101, I covered the basics around mutual fund and exchange-traded fund (ETF) distributions and defined some key terms. I also cautioned IVA readers against “buying a dividend” or putting money into a fund right before its distribution date. Additionally, I repeated my suggestion that investors send distributed payouts to cash as an efficient strategy for rebalancing and managing a taxable portfolio.
Here, I’ll discuss two strategies for reducing your capital gains-related tax bill: holding index funds in your taxable account and tax loss harvesting.
Key Points
- Vanguard’s ETFs and index mutual funds are more tax-friendly than their actively managed mutual funds.
- If you are going to sell a fund at a loss to reduce your tax bill, don’t buy any shares in that fund in the 30 days before and the 30 days after the sale. (Reinvesting income counts as a purchase, so beware.)
ETF or Mutual Fund
One increasingly popular strategy for keeping capital gains down is to buy exchange-traded funds (ETFs) over mutual funds in your taxable account. You’d then stash any actively managed funds in your tax-deferred accounts, where distributions aren’t a worry.
This is logical: ETFs typically pay fewer capital gains than mutual funds. You can read the nitty-gritty of why that is here.
The chart below is the proof behind that blanket statement. It plots the average capital gain (as a percentage of price) distributed each year over the past two decades by three different groups of Vanguard funds: (1) actively managed U.S. and foreign stock mutual funds; (2) U.S. and foreign stock index mutual funds; and (3) all of the firm’s stock ETFs.