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Believe it or not, some people actually have money beyond what they have accumulated in their retirement accounts. Retirement account money is referred to as “pre-tax” or “tax-deferred” because no taxes are ever due until you spend it. All that money keeps compounding tax-free. Everything else is called “after-tax money.” The genesis of after-tax money for most people will be some combination of the sale of a home, business or an inheritance. Miraculously for some, however, their after-tax portion of the nest egg is attributable to disciplined savings and investment acumen.

A major challenge in managing after-tax money is the effort to minimize taxes created by the extent to which an investment strategy leads to success over time. With state and federal income taxes eating up roughly 25 to 35 percent of any gains, it brings to mind Chairman Mao’s old adage “One step backwards --- two steps forward.” Avoiding the step backwards has much to say for itself.

Index mutual funds and Exchange Traded Funds are tools that help control the tax problem created by successful after-tax investing.

In most years, a mutual fund generates taxable income to its investors. The fund buys stocks low and sells high and information regarding the taxable profit is passed on to the investor on a form 1099 which tells the IRS how much the investor owes in taxes as a result of their proportionate share of the fund’s success. Some funds don’t trade much. In this case, the investor may pay a small amount of tax from year to year, but when he or she finally sells the fund, they owe a capital gains tax on the difference between what they originally paid and what they sell their shares for --- BUT, they get to subtract from that total the amount that they had paid on gains in the intervening years. Mutual funds are valued at the end of every business day based on the share prices of all of the shares in the fund as of the close of the market.

An Exchange traded fund is different. Shares are created and sold to investors and the underlying securities are provided in bundles by financial institutions that are “authorized participants.” Meanwhile, the ETF shares are traded on exchanges as if they were actually company stocks themselves. Almost all ETF’s are indexes or baskets of securities that represent, for example, the S&P 500 companies. Because these ETF shares are traded from second to second throughout the day, their price can become disconnected from the combined value of all the securities that presumably make up the fund. Simple supply and demand causes the share price to fluctuate during the day --- not necessarily changes in the combined value of all the underlying securities. The latter would be impossible to calculate from moment to moment. As best they can, ETF providers try to maintain enough underlying securities to match the value of all outstanding shares. Warning: an attempt to read and understand the prospectus of an ETF can give you a severe headache.

The advantage of ETF’s from the after-tax investor’s standpoint is that their buying and selling is extremely well tax-managed and the only trade triggering a tax is the eventual sale of the ETF fund shares for a profit. It’s like owning a conventional mutual fund that never makes a trade. There are little capital gains assessments recorded on 1099’s to speak of because the investment is in a single stock. It’s more like buying a share of AT&T and holding it forever.

Before getting all excited about ETF’s, we have to remember that the many hundreds of traditional index funds offering different cross sections of the stock market have very little turnover or sales of securities within the fund --- typically about 6 percent or less. Therefore, the taxes they trigger from year to year are minimal. By comparison, the turnover in an ETF is even better --- often less than 1 percent as measured by tax cost.

Bottom line: the longer you can hold on to money and control what you have, the better. Keeping this control for the buy-and-hold after-tax investor allows for the saving and compounding of what would otherwise have disappeared in taxes.