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Are you trying to learn how to deliver massive tax value to your clients? Then look no further. Retirement Tax Services Podcast, Financial Professional’s Edition is a show hosted by Steven Jarvis, CPA. Steven aims to bridge the gap between tax professionals, financial advisors and their mutual clients in their quest for reducing tax expenses in retirement.
In this week’s episode, Steven gets the chance to really nerd out as he is joined by two guests from Dimensional Fund Advisors to get into the weeds on the tax implications of investing. John Wilson and Joe Hohn (who used to be an aerospace engineer before becoming a fund manager) share their perspective and insight on just how much taxes play a role in investment selection and management. This episode is a bit more technical but still gives any advisor great information they can apply to continue elevating their tax game.
Steven and his guests share more tax-planning insights in today’s Retirement Tax Services Podcast. Feedback, unusual tax-planning stories, and suggestions for future guests can be sent to email@example.com.
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Hello everyone, and welcome to the next episode of the Retirement Tax Services podcast, Financial Professionals Edition. I’m your host, Stephen Jarvis, CPA, and I’m really excited today to be joined by two guests from Dimensional Funds so that we can nerd out on taxes and investments. John, Joe, welcome to the show.
Thanks, glad to be here.
Thanks for having us.
So John, I’ll start with you. Why don’t you give just a little bit of background about your role at Dimensional Funds and we’ll kick it over to Joe and then we’ll really start into the tax stuff.
Yeah, sure thing. So John Wilson Dimensional. I’m a regional director. I spend the majority of my time working closely with independent RIAs and the up and down the East coast for us. And that entails working with firms on investments well as communication messaging, as well as business strategy, all three key pillars of Dimensional service offering.
That’s fantastic. And actually, John, you and I got introduced through PJ DiNuzzo, who I co-wrote my book with. He’s been a longtime user and fan of Dimensional Funds. So, I always love bringing people on the show where I can have these glowing recommendations from people of, Hey, you’ve gotta go talk to these guys at Dimensional. So, and then you invited Joe to come along. I think you introduced him as a giant nerd, which that’s music to my ears. So Joe, welcome as well.
Yeah, absolutely happy to be here. And I am a giant nerd, so I’ve been here at Dimensional for just over 11 years now managing all kinds of assets, separate accounts, mutual funds across the globe. Eight years ago when we first got into ETF management, I was one of the first portfolio managers helping to manage those funds. And so I’ve been managing ETFs for the last eight years. The last three, we’ve been really pushing the entire industry along with the new active ETF structure to do things that they’ve never done before. And so we’re really looking to innovate there and we’ll talk more about some of that as we go through this conversation. But the nerd part comes from, before I came to DFA, I was in aerospace engineering for 10 years kind of building and operating satellites for the government, for various government entities. So I loved it. It was fantastic. But I’m very happy to be here at Dimensional now.
That’s awesome. That’s a really cool backstory. So really what I wanna focus on today, since this podcast is all about tax planning, I spend a lot of my time talking about things we can proactively do kind of outside of investment choices. I’m just not an investment guy, but obviously the investments that we have have a big impact on our tax return. And part of where this conversation comes from is really just my own observation. I think you guys share this, that a lot of times when investments in taxes get talked about in the industry, it’s not with a high degree of nuance. It’s almost kind of a, well, they are what they are. Everyone’s tax efficient now, so don’t worry about it that much and it kinda gets glossed over. But I mean, Joe, as you’re intimately familiar with that, that’s not that simple. Like there are people behind the scenes making important decisions that impact what happens on a shareholder’s tax return.
Yeah, absolutely. I mean, you’re right. A lot of clients look at portfolios and they say, okay, the best you can do is not distribute capital gains. And we know that that certainly isn’t the case. We’ve been managing mutual funds for decades, and mutual funds don’t have quite some of the tools in their toolbox that ETFs have. And because of that, it means that mutual funds tend to distribute capital gains, whereas an ETF counterpart might not. And we can talk about some of the reasons behind that. Now, with that, our mutual funds have distributed capital gains, but if you look at the actual after tax characteristics of our mutual funds, they are competitive on a tax efficiency ratio level versus what most people would think of as more tax efficient products and ETFs. And why is that? It’s non-qualified dividend income. It’s all these other little things that we’re doing around the edges. And so we’ve sharpened our pencil for decades on managing assets, managing funds really well that way. And now we’ve also got ETFs where I’ve got this new tool in my toolbox where I can go ahead and hopefully keep the funds from distributing cap gains on top of the other stuff that we’re doing.
So John, you work with advisors, you said, all up and down the East Coast. A lot of times when I’m hearing advisors talk about different investments, they talk about just very broad generalizations of, well, I do ETFs or stay away from mutual funds. Again, there’s not a lot of nuance as to what you should be looking for or even how to distinguish these. So I guess, what have you found to be an effective way to communicate on this topic as far as what are the distinctions, which ones are meaningful and which ones are more just kind of glamor online?
Well, I think it certainly starts with, you know, the situation, right? Are we talking about a non-taxable account for client, or we’re talking about taxable account? And then oftentimes when ETFs come about, it’s taxable accounts, right? And the push forward over the years pertains to just the amount of ETFs available, you know, has made the offerings a whole lot more for advisors. Commissions is another thing that’s kind of pushed some of this forward, you know, and most platforms out there, you can buy or sell your ETFs commission free mutual funds, those may still have a commission tied to them, depending on fund family, depending on custodian and the like. And now you have mutual funds and ETFs across many providers where they’re the same offering. So it comes down to what’s the current situation, right?
And now ETFs went through a big push in 2019, and I can let Joe kind of speak to that. And that’s where we’re having lots of conversations with folks is, well, the ETF rule that the SEC brought through at the end of 2019 that really pushed us forward and had a little bit stronger presence in the ETF space and innovating. Joe used the word innovation. What does that mean? ETFs Or ETFs? Well, not all ETFs are created equal. And, that’s an important piece that we’ve been innovating towards. And so Joe, maybe you wanna speak to a little bit of the ETF rule for those that might not be familiar, and that’ll probably be a lot of the why you see so many more ETFs being launched today. Well, it starts with the ETF rule.
I mean, it used to be before the ETF rule that each issuer had to go to these SEC and get it what was called an exemptive relief to get relief from certain portions of the PORTEE Act, depending upon when you got that relief you got, there were different vintages of it, different regimes of the SEC approved different things. What the SEC came through and did is they kind of wiped all that away. And they said, here is one set of rules. As long as you operate two, you all can have ETFs, issue ETFs and not have to come and get an exemptive relief from us. And so what that meant is a whole lot of issuers now could, number one, they didn’t have to get the exempt exemptive relief so they could come out and launch ETFs.
And number two, it also gave active managers a whole heck of a lot more flexibility in how they managed products. So a lot of the new ETFs you’re seeing are actually active ETFs because new things that we can do. But like John mentioned, not each ETF is the same. And a lot of issuers said, okay, all flow is going to ETFs. My clients are asking for ETFs. I don’t know how they work. I’m just gonna launch one and I’m gonna do it in the least efficient way possible, but I just need to check that box. We don’t do things that way. And in fact, before we manage or launched our ETFs, I had five years of ETF management. So when we came out, we had cream of the crop, best of breed ETF management processes and systems in place from the very beginning.
So, Joe, talk to me about how advisors or even really consumers can look at this when they’re going to make decisions. Because again, I am not the investment guy. Yeah, but I mean, I hear people so often talk about this in broad categories, and they, I think they’re making you know overly simplistic assumptions about, oh, well, ETFs are always gonna be more tax efficient, so I just need to pick an ETF. And there’s not really the additional, well, which one or how do I know where the tax efficiency comes in? What should I be on the lookout for? What’s gonna tell me this is more or less tax efficient?
Yeah, absolutely. So step one I always say for clients is figure out what your investment philosophy is, right? If we have our investment philosophy, we think it’s great if you agree with that. We’ve got a lot of products out there that we think will work well for you, but step one is always figure that out, because if you end up buying a product that has an investment strategy that you don’t believe in, you aren’t gonna be happy with what you see. You aren’t gonna understand the return stream that you see. So I think that’s always step one. Then step two, when you go and look at ETFs, you wanna look and see a few different things you wanna see, all right, what are they doing? Are they index versus active? If they’re indexed, what index are they managed to? How efficient is that index?
Because indices were made decades ago not to have assets managed to them, but to benchmark managers. And they weren’t built for concerns and considerations of the real world. In fact, when you look at a lot of indices out there, and I live and breathe this every day when we see corporate actions come up, we literally get a question from a company and they say, do you want a hundred dollars or do you want $90? Literally, this kind of a situation happens. And as a fiduciary for the fund, I’m like, of course I want the a hundred dollars. Why would anybody take the $90? You know, who takes it a lot of times is indexers because it lowers tracking error. Now, when you look at your product and you look at your investment outcomes, do you really care about tracking error or would you rather get that $10?
Would you rather have an investment manager who’s picking up that penny along the way? And that is certainly us. And so indexing has its flaws. And so, you know, you should understand what those flaws are. If you look at active, then you’ve gotta dig into it just like you would any mutual fund historically, right? You’ve gotta understand what that active manager is doing. And again, for us, we’ve been around for four plus decades, you know, what we’re doing is systematic, it’s straightforward and it’s repeatable. So we’re kind of in a sweet spot there. Once you’ve gotten that figured out, then you want to go and see what are they distributing, what are the capital gains that are being distributed? ETFs are not immune to cap gain distributions. They’re absolutely not. There’s a ton of work that needs to be done in the background on the management of ETFs to build up capital loss carry forwards to make sure that we are getting to a zero cap gain distribution each year.
A lot of us can do it because we’ve got tools in our toolbox that allow for it, but it certainly is not guaranteed. And I think with the active ETF space getting bigger and bigger and markets kind of being up and down, I think you are gonna start to see more ETFs actually distributing cap gains. So I would have an eye toward that. And the last thing that I think is most nefarious for folks is to look at the flavor of income that’s being spun out of these products. A lot of products have really low qualified dividend income, and that is really bad. A bad tax. It could be a bad tax outcome for individuals depending upon their circumstances where there could be a really big tax bill that comes from that. And so those are kind of the steps that I would go through in evaluating products.
You hit on some really great things in there. I mean, what a couple that I wanna highlight that I see from the tax return side as well, particularly around capital gain distributions, and then you talked about is flavor of income qualified versus ordinary dividends. Capital gains distributions is one of these areas where, so sometimes all we’re left with is just being able to help clients set expectations of making sure that we’re not getting surprised by this, but it’s certainly something that we want to understand cuz you know, capital gains aren’t inherently some evil thing. But if you get, especially where this really gets people mad is when the market is down for the year and don’t understand how they could possibly get a capital gain distribution, which I mean the knowing smiles on your guys’ faces. I’m sure you deal with this all the time, but that kills people when, wait, the market was down 20% this year, how did I have a $10,000 capital gain?
And it’s like, oh, well those investments have been held anyways. You guys know this. The other piece that Joe, I’d love for you to maybe speak to just a little bit more as far as like how a manager like yourself would have an impact on this. Is that ordinary versus qualified dividend? Yeah, because I think as a lot of taxpayers, a lot of advisors see that, they see that line on their tax return, like, you know, 2A and 2B, since I’m a tax nerd to know those things of it, it just, it feels like, hey, this is just something that happened to me, like, there’s no controlling it, there’s nothing really to do about it. And since the tax return doesn’t actually ever do the calculation for you of what your tax liability is, it’s just a black box. People don’t necessarily recognize the importance to the bottom line of how much of their hard-earned money the IRS kept of making that distinction. Because there’s a big difference in how much money IRS is asking for, whether it’s qualified or ordinary dividends.
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For sure. On the first point with the cap gains when markets are down, just yeah, we live this, there was a few years back where our fiscal year is different than individuals calendar year, which is the fiscal year for them. Our fiscal year ends at the end of October. A few years back there we had markets where for our fiscal year markets were up nicely and the capital gains that got, they got solidified at the end of October.They made complete sense given where markets were at, you know what, November, December markets went way down and we had a bunch of clients who were like, what the heck is going on? And so just, there is a bit of a mismatch there. The other thing is, like you mentioned it, Steven, these, a lot of our mutual funds have been around for a long time.
They’ve got tax lots that have some gains in them. You know what, I’m a fiduciary to that fund. And the number one thing that I signed up for in that fund is giving you the investment strategy that I promised you and you know what, I’m gonna be doing that. And it, in a mutual fund structure where we don’t have the tools that we have for an ETF, it might be that I end up having to realize capital gains, but I told you I’m giving you a value product, so I’ve gotta sell some gainers that have moved out to the growth area to get the assets pushed back into the value space. Now for ETFs, we’re very bullish, very optimistic that we’re gonna be able to do both of those things at the same time, manage the capital gain distributions, and keep the investment strategy where we want it to be.
On the flavor of income qualified versus non-qualified, there are a few things that we can do. So a while back we made the decision to say, REITs real estate investment trusts, we said they’re great. There’s, we have no problem with them. We have REIT ETFs, we have REIT mutual funds, but we said, we think that’s a separate asset class to equities. If we are, say you take a Russell 3000 kind of product, you’re gonna have a handful of percent in real estate exposure and that product. And what we heard from our clients was they say, I already own my house. I own that building down there. I own this other stuff. I’ve got plenty of real, and it’s levered real estate exposure, right? Like, I don’t need anymore, don’t give me anymore. So please take that out of equities. And so we removed REITs from our equity exposure and we give the power to our clients to allocate as they see fit to real estate.
The other knock on benefit of that is REITs all of the income that they spin off and they have high div yield is non-qualified. And so at the end of the day, our flavor of income distribution ends up being better because of that. Now, that’s not the only thing we’re doing to make our flavor of income distribution good. We’re doing a lot of management around securities lending. So, this is getting nerdy, getting deep into the weeds, but if we have a security out on loan and it pays a dividend, that dividend comes back into the fund. So, we are completely made whole. It’s not like whoever we lent the security out to, they keep the dividend and we don’t get it. We get it, but it changes form, it changes form from qualified into non-qualified dividend income.
And so we are proactively looking at dividends that are coming up and we’re looking at the QDI and qualified versus non-qualified dividend income status of our funds and proactively pulling back loans so we can get those securities back. So we get the dividend, it comes in as QDI, and then we can put the security rate back out on loan. And so we do a ton of work around that. And the last thing I’ll mention here is, as I’d be really careful, when you’re evaluating products, and you look at some of these, especially what I’ve seen are income products that are out there these days and the way that they’re able to generate really high income distributions, you know, we’re talking nine, 10% income distributions, which is way above the yield of any kind of equity investment you could get. What they’re doing is they’re doing it through structured products. And what ends up happening there a lot of times is it transforms a lot of that income distribution into non-qualified. And so just be really careful of that. If you look, it’s not the easiest thing to find, but if you look at pre liquidation after tax returns and compare them to the normal returns, you’re gonna see a tax drag there. And I would look at that for investment strategies and to see really when the rubber hits the road, what is the tax drag for what you’re doing in these products.
I appreciate you taking the time to kind of go through those levels because there’s certainly layers to this that it’s not as simple as one product is tax efficient and the other is not. And I would imagine that it’s different from manager to fund manager as well.
To be certain, right? In summary, what are the levers when it comes to taxes from an investment vehicle, ETF or mutual fund to your long-term capital gains, that’s gonna have an impact that gets attributed short-term capital gains, that’s gonna have an impact. And then the income. So it’s kind three key levers and understanding what your investment approach is doing across each of those levers is important. I think ETFs, there’s an assumption that the short-term capital gains and the long-term capital gains that defer, don’t worry about it. You have, be careful with that. That’s not a guarantee. There are mechanisms in place that have allowed that to occur and we continue to occur. But once you go outside the United States, there’s some things to be aware of. So expectation settings, a lot of what we try to do dimensionally, even though we’ve been in the ETF space three years, sub advising for eight, nine years, gotta be careful.
And that pillar in the income. There are controllables. So Joe just outlined REITs, do you want those or not? There’s a trade off with taxes. If you could include REITs in your investment portfolio, it could be chasing high dividend income. There might be trade offs. What is the qualified versus non-qualified, but also when it comes to moving securities in and out, there are things we do too. And Joe, maybe just to finalize the income pillar that we think it’s really important if you’re looking at an investment approach to understand is how are you buying and selling stocks around dividend x dividend dates, right? Because we do see that have an impact of whether or not your dividend is qualified or non-qualified. We’re hyper-focused on this little detail. Most investment approaches are not, and this is why we have typically higher QDI rates across our funds than any other asset manager.
It really goes to the benefits of active management versus indexed. If you’re indexed, you’ve got a right answer every day. And you know what, if your goal is zero tracking error, you’ve gotta be that right answer every single day. What that means is you could be taking in securities via creation, via people buying on market on one day, and then that security could be paying out a dividend the next day. Then the day after that, maybe somebody redeems your fund and you end up having to relieve that lot that you just had created from for few days prior. Well, guess what? That dividend that you just got from that security, it’s switches into QDI as well to non-qualified dividend income. And so the flexibility that we have, and we literally, when we are putting together our baskets and ETFs, transact and baskets of securities, when we’re putting those together on a day by day basis, we are worried about all of this. When you think about an index manager, it’s just a silly pro rata slice of their fund. They don’t care one bit about any of this because the tracking error is king for them.
So Joe, is it most things you describe all of this, like there’s part of me that I love all the numbers behind things, but I’m thinking about my audience, the advisors I typically work with, and I haven’t asked all of them, but most of ’em do not have extensive experience launching satellites and tracking trajectories. They don’t have extensive experience actually managing funds and getting into the weeds and all these things. So where’s the balance? How does someone who’s an advisor who cares about these things but is not going to try to replace you, how do they learn more about this? What’s the best way to to educate yourself to be able to help a client without going full fund manager on someone?
That’s a really good question. I dunno, what I do is, like I said, look through some products and look at those pre and post liquidation returns. I think they’re really eye-opening. You can learn a lot from a product there. It’s tough sometimes to find the qualified versus non-qualified percentage of income when you go out to different tax centers on issuers websites but, you know, you can’t hide when you’re looking at pre and post liquidation return numbers. And I think that’s just a fantastic starting point. You can’t hide at that point. There can be a lot of fluff. You can say you’re doing all this great stuff and whatnot, but when the rubber hits the road and you see that there’s a lot of tax drag, I think that’s a good place for it.
Always love the recommendation to go look at the real numbers of constantly talking to advisors about getting tax returns, looking at real numbers. You can’t just stay at the very highest level.
John, anything you’d add from an advisor education standpoint? I mean, as you know, as you’re talking, as you’re working with advisors on working with Dimensional funds, I mean, there’s gotta be questions that come up and it’s this balance of, again, there’s a reason you go hire a professional to do anything. But how do you balance that education level for the end user?
Yeah, I think it all actually really comes back to what Joe had mentioned just a little while ago, which is the philosophy. That helps iron out a lot of things. And some of these stresses is understand kind of what’s the investment philosophy gonna be? And then you can kind of start to weed through what vehicle are you gonna go with, and then from there, okay. What’s the investment approach from this vehicle me mentioned this before, I’ll mention it again. Unfortunately, it’s going to get messier, I think in the years ahead as it pertains to Yeah. ETFs where the blanket nomenclature is ETFs are tax efficient. They are not all created equal, but there’s gonna be so many different ETFs out there, you don’t really understand what you’re trying to do. It’s gonna be one of those things where you’re gonna be grocery shopping.
You’re gonna wind up just with a bunch of different solutions and then you’re gonna have that uh oh moment, which is uh oh. This one was an ETF, didn’t really understand exactly what I was doing under the hood. Butts gave me a capital gain distribution, which I don’t understand how that’s possible or how that happened. So it comes back to a lot of that philosophical spot, and then asking those questions that I mentioned earlier around, okay, those pillars, income, what are they doing to be able to maybe manage income in a more qualified manner? Making sure that maximizing qualified and dividend income in the portfolio, and then, hey, short and long term capital gains, what are they doing? Is there a lot of turnover in this solution? Right? Is it concentrated? Those just start to ask questions that may lead into, there could be a uh oh moment one day. Needless to say too, the current situation for ETFs is beneficial because of law. Laws can always change. So then that’s where those questions are really important to make sure you ask on the front end to understand. Cause if kind of the current process gets taken away, so to speak, you’re left with a concentrated solution, has a lot of turnover, well that probably means it’s not gonna be very tax efficient if the tax efficient mechanisms and ETF get taken away. So for consideration.
I like to remind people that the tax code is written in pencil, but that applies to all rules and regulations that come from the government. So yes, they can change at any time. Well, I certainly appreciate both of you coming on and sharing your insight and expertise on these things. Like I said, this is something that’s outside of my certainly my expert knowledge. I’m aware of these things, but always appreciate learning from the experts. If people listening are wanting specifically to learn more about how Dimensional funds approaches these things or get involved with what you guys are doing, what’s the best way for ’em to follow up and reach out and learn more?
For sure. We’ve got a good public website, us.dimensional.com. You’ll find good broad overview about the firm if you’re not familiar, and certainly an opportunity to reach out directly if we can help answer questions, demystify certain things about dimensional for a firm that’s been around 41, 42 years. What typically leave you with is dimensional, more sophisticated than an index, more reliable than conventional active management. And we continue to innovate and push on behalf of investors. So we’re fighting for basis points to, I think in the years ahead, Joe and team are doing some really neat things that hopefully we keep making things more tax efficient and more reliable for investors.
Well, I certainly appreciate that we’ll get everything linked in the show notes so that people can get out and learn more about what you’re doing. We always like to wrap up these episodes of action items so that people are taking information and turning it into value. So certainly go out and learn more about what Dimensional Funds is doing. Whether you use Dimensional funds or whoever you’re with, make sure you’re asking these questions you need to have in your process that yes, you’re hired an expert to do some of this for you, but you are there, you’re the expert on behalf of your clients. You need to understand these things. You need to continually elevate your knowledge. And then of course, I’m always gonna encourage that we’re getting tax returns for every single client every single year. And this certainly is one of the things you should be reviewing on the tax return of what is the taxable impact from their investments. So, there’s certainly a lot more under the hood that you’ll have to dive into, but the tax return’s gonna give you a very real place to say, are my clients getting hit with taxes because of their investments? So those are all things that we can be doing to make sure that we’re elevating our game in this area and make sure we’re delivering value to our clients. John and Joe, thanks so much for being here. I really appreciate your time.
Absolutely. Thanks for having us.
To everyone listening, thanks for being here. And until next time, good luck out there. And remember to tip your server, not the IRS!
The information on this site is for education only and should not be considered tax advice. Retirement Tax Services is not affiliated with Shilanski & Associates, Jarvis Financial Services or any other financial services firms.
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