Before investing in either an ETF or a Mutual Fund, it is best to understand how different investment accounts work. An investment account can store both ETFs and Mutual funds, and the decision for picking an account should be based on tax benefits, access to the funds, and the need for a collateral loan. There are three types of accounts, and here are their general characteristics(not all included):
Taxable
- Can be used for collateral loans
- Short term gains at taxed your current marginal tax rate
- Long term gains at taxed at either 0%, 15%, or 20%
- Every transaction is a taxable event
- Dividends are taxed as ordinary income
- Investment turnover can result in a capital gain
- Can write off losses
- No early withdrawal penalty
- Have to consider the wash rule
Tax-Deferred (401k, Traditional IRA, 403b, 457, TSP)
- Get a tax break for contributions and pay taxes when you take the money out
- Investments grow taxed deferred, and dividends and investment turnover doesn’t result in a taxable event as long as the money stays in the account
- Typically want to invest money into these accounts when in a higher tax bracket and will be a lower tax bracket when the money is withdrawn
- Subject to Required minimum distributions at age 72
- Early withdrawal before 59 1/2 typically has a 10% penalty
- Can’t write off losses in the portfolio
Tax-Free (Roth IRA, Roth 401k, Roth TSP, Roth 403b)
- Don’t get a tax break for contributions but don’t pay taxes on withdrawals
- Investments grow tax-free, and dividends and investment turnover doesn’t result in a taxable event as long as the money stays in the account
- typically better for investors who will be in a higher or the same tax break in the future.
- Not subject to required minimum distributions at age 72
- Can withdrawal contributions at anytime
- Earnings are subject to the five-year rule in an IRA
- Can’t write off losses in the portfolio
- 10% penalty on earnings if withdrawn before 59 1/2
There is nothing that says that you have to stick with one investment account for the rest of your life, and someone could have multiple of each one if they choose to and meet the guidelines.
How Jumps In Income Should Affect Your Account Decision
Depending on your situation, will determine which of the accounts you choose to fund at that time. Right now, traveling nurses are making a lot of money with the pandemic. They will probably see their income jump from 24% to the 35% tax bracket, so it might be a good idea only to fund a traditional 401k until the covid-money runs out and then switch back to a Roth 401k when they drop down to a lower tax bracket. As for a lot of things, the situation determines the financial plan someone should take.
Breaking down ETFs vs Mutual Funds
When it comes to fueling the investment vehicle, it can be done by individual stocks, individual bonds, mutual funds, and ETFs for the most part. Now, this discussion is going to between ETFs and mutual funds.
With ETFs and mutual funds, both can be index funds similar to an index like the S&P 500. Both investments will have the same companies and percentage of those companies inside of them. The most significant difference is that ETFs trade in shares, and mutual funds trade in dollars.
If an ETF costs $300, and someone only has $100 to invest, you can’t buy that ETF. You have to wait until you have $300 to buy it. If a mutual fund costs $300, and someone only has $100 to invest, they can buy a third of one mutual fund. Some investing platforms are getting into fractional shares with ETFs, but it is not a common practice now, and that fractional share might not be able to move to another platform if needed.
Cash right now in Oct 2021 has a 0.01% APR in a bank account. By having the money stay in cash, it won’t benefit if that mutual fund appreciates. Waiting three months to accumulate $300 could miss out on a market rise. Putting aside a set dollar amount every month is known as dollar-cost averaging, which over a long term period, and tends to be a better strategy for investing than waiting to accumulate the funds and doing a lump sum at a future date.
If someone wanted to sell an ETF that is $300 per share and only needs $100, they would need to sell the entire share and then figure out a way to invest the other $200. With a mutual fund, someone could take out the $100 and keep the remaining $200 still invested in the market. Understanding your liquidity needs and when you need the money can help you decide what you should do for your investment choices.
For buying and selling, the price of a mutual fund is determined at the end of the day. ETFs will use the market price since they are traded like a stock. With an ETF, you can better take advantage of market prices and be more effective with rebalancing and reallocating an investment portfolio.
Tax Considerations
ETFs are usually better for taxes because you rarely have to worry about capital gains from portfolio turnover since they are owned in shares. With a mutual fund, every investor has money into a fund, and the value is recalculated at the end of the market day, based on the fund’s inflow and outflows and the fund’s performance.
If an investor with a large holding of a mutual fund decides to sell all their shares, this will cause the fund managers to do a bunch of rebalancing to get the fund where it needs to be. This vast outflow can cause every investor to see a capital gain and pay taxes on those gains even though the other investors didn’t pull any money from their account since the funds are comingled.
This capital gain from rebalancing is not a problem if the money is in a tax advantage account since money is only taxed when withdrawn. A Roth would be a tax-free withdrawal if meeting the proper requirements. If the mutual fund is in a taxable account, the investor should receive a 1099 from the custodian for the capital gain.
Fee Considerations
When it comes to fees, it’s a discussion about active vs. passive. Passive Index funds for ETFs and mutual funds will have similar low internal expenses with an average fee of 0.06% in 2020. With a mutual fund, if you’re working with a broker-dealer, there might be a 12b-1 associated with the fund and is an operational expense and covers the cost of distribution, including marketing and selling mutual fund shares. This 12b-1 fee is typically 0.25%
An actively managed mutual fund averages an annual expense ratio of 0.71%, not including the 12b-1 fee. The average active ETF had an asset-weighted average expense ratio of 0.69%. The fees are very similar between mutual funds and ETFs when they are actively managed or passively managed. Since 80% of passive funds outperform active funds over 15 years, it is more dependable to pick passive funds with low expense ratios and other fees.
The Difference Between RIAs and Broker-Dealers
As a fee-for-service advisor, I mainly charge a monthly subscription fee to provide financial planning, and I can also do a project-based fee. I can give investment analysis, tax planning, risk management, cash management, estate planning, and retirement advice.
By being a registered investment advisor, it is a legal requirement to act in the best interest of my clients under the Advisors Act of 1941 and that clients pay me a fee that is not tied to third-party compensation. I prefer to do a passive investment strategy and focus on different segments of the economy. Still, if someone wants to add some active funds to their portfolio, I would give them the pros and cons of that decision, show them their options and potential outcome, and it would be up to the client to decide what to do.
A broker-dealer is in the business of selling financial products and makes a commission off their sale of a financial product like a mutual fund which would have a sale charge of 5.75% that is subtracted from the contribution amount. So there might be an incentive for the broker-dealer to convince the investor to buy their funds over something else.
Holding companies hire these broker-dealers to sell their commission products, and broker-dealers typically only sell products their company has approved. So an investor might not be getting full access to all investments. The commission is there to compensate the broker-dealer for setting up the account for the client and helping them select the investment. Active funds can outperform their benchmarks, but 80% of them typically don’t. When you add the 12b-1 and sales charge fees, they probably won’t outperform the benchmark, but that fee should be looked at about the value an investor receives from the broker-dealer.
These commissioned funds could be acceptable, but a broker-dealer doesn’t follow the fiduciary rule. They follow the suitability rule. The suitability rule from the Securities Act of 1935 generally states that the sale of the security has to be suitable for the investor. It doesn’t mean that it is the best for the client.
It is like going to a tailor for a suit. Under the suitability rule, the tailor only has to ensure that the suit fits, while a tailor under the fiduciary rule has to ensure it fits and looks good. Just understand the fees you’re paying and what makes the most sense for you and your situation. I know I work in a confusing industry, but these are the rules, and I choose to work as a fiduciary to add fewer conflicts of interest to my clients.
Final Takeaways
Generally, I see it is best to place ETFs in a taxable account and Mutual funds in advantageous tax accounts as a general strategy. There are some caveats to this strategy, and many other factors determine it, but the investor must know the deal before accepting it. Knowing the deal involves knowing about taxes, performance, different investment segments, financial risk, liquidity needs, estate goals, fees associated with the investments, and the overall value that will be generated.
*Links to other sites are for educational purposes only and is not an endorsement of that company or fund*
*Before you make any changes to your financial plan or portfolio, please do your research or contact a professional like myself to minimize financial risk and mistakes*
