Build a tax-efficient portfolio with these funds, Bank of America says
Taxes are top of mind for investors as April 15 approaches, but there are a few steps investors may consider now to reduce tax drag on their portfolios. April 15 is the deadline for taxpayers to file their income tax returns and pay sums owed for 2023. While there isn’t much you can do now to cut last year’s levies, now might be a good time to rein in those expenses for 2024. “Investors should audit portfolios to understand where tax costs can be lowered,” wrote Jared Woodard, investment and ETF strategist at Bank of America, in a March 12 report. “Many ETFs take advantage of [qualified dividend income] & return of capital for tax efficient distribution.” Taxable income sources Woodard identified four sources of taxable income. First, there’s qualified dividend income, which is taxed at favorable long-term capital gains rates of 0%, 15% or 20%. Then there’s return of capital, which is untaxed in the current year and lowers an investor’s cost basis in an investment. Third, there are long-term capital gains, which apply when you sell an investment you’ve held for more than a year and are subject. Finally, there are ordinary dividends and short-term capital gains, which are subject to the same rate as ordinary income – a top rate of 37%. For investors seeking tax-advantaged income, master limited partnerships offer attractive yield and a way to play energy. These MLPs, which include pipelines for the transport of oil and gas, have general partners that run the daily operations and limited partners — that is, individual investors — who buy interests and provide the partnership with capital. MLPs themselves aren’t subject to federal income taxes, but limited partners owe taxes on the income distributed. That’s different from being a shareholder in a C-corporation, where the business pays income taxes, and the investors pay taxes on income received. Due to this tax treatment, MLPs can offer a solid yield. Rather than picking out individual MLPs, investors can consider owning an ETF that holds these partnership interests. In particular, Woodard called out Global X MLP & Energy Infrastructure ETF (MLPX) and Global X MLP ETF (MLPA ). “80% of MLPX & MLPA distributions last year, on average, were classified as return of capital,” he wrote. “Yields today are 5-7%.” MLPX has a total return of 7.6% in 2024, and MLPA’s year-to-date total return is 9.3%, according to Morningstar. Both have total expense ratios of 0.45%. Qualified dividend payers Investors may also want to consider ETFs that spin out qualified dividend income, which is subject to lower favorable tax rates. “Dividends paid by US sector funds like IYK ( iShares US Consumer Staples ETF ) and XLU ( Utilities Select Sector SPDR Fund ) with relatively high yields are classified as 100% QDI,” wrote Woodard. “The same is true of broad equity funds that most already own like SPY ( SPDR S & P 500 ETF ) or VOO ( Vanguard S & P 500 ETF ).” In 2024, IYK has a total return of nearly 4.7%, while XLU’s total return is about 0.7%, according to Morningstar. XLU has an expense ratio of 0.09%, and IYK’s expense ratio is 0.4%. For those seeking exposure abroad, Woodard highlighted the iShares MSCI Indonesia ETF (EIDO ), the iShares Latin America 40 ETF (ILF) and the iShares International Select Dividend ETF (IDV). “Dividends paid by eligible foreign companies can be taxed at lower rates,” he said. “For example, EIDO, which tracks Indonesia, has 100% qualified dividends. ILF, a Latin America fund, pays 93% QDI.” Closed-end fund plays Closed-end funds are similar to mutual funds – they trade publicly on exchanges – but they offer investors a fixed number of shares. That means their share price may trade at a discount or a premium to their net asset value. These funds can also use leverage, which may result in enhanced returns over the long run, along with the potential for volatility. “Leveraged muni bond CEFs trade at -10% discounts, well below norms and offer a 6-7% tax-adjusted yield,” said Woodard, noting that these muni bond funds offer tax-exempt payouts. “We’re cautious near term as leverage costs remain elevated but investors with a longer time horizon can capture value.” In particular, he highlighted MFS’ Municipal Income Trust (MFM) and the Nuveen Municipal Credit Income Fund (NZF). MFM’s total return this year is 3.66%, and NZF has a total return of 3.4% in 2024, according to Morningstar.
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