Insights

Leaving Money On the Table Does Your 401(k) Structure Maximize Tax Benefits?

ERISA collective investment trusts can reduce the tax burden when investing internationally.

Head of U.S. Investment Strategy, DC

Tax season highlights for all of us the impact taxes can have on our income and investment returns. While many of us think of defined contribution plans as being tax exempt, that is strictly true only for domestic taxes. When investing in an international equity fund, participants may still incur taxes on capital gains and foreign dividends. Choosing to utilize an ERISA collective investment trust (CIT) over a mutual fund can reduce the taxes paid when investing internationally. In fact, while CITs and mutual funds are similar, key differences, such as how they are regulated, their cost structures and the degree of flexibility that each may offer plan sponsors, can have a meaningful impact. In the case of CITs, their tax-efficiency translates to better long-term results, keeping more money in the fund and, ultimately, in participants’ pockets.

How so? Let’s focus on taxes related to dividends. Mutual funds, as registered investment corporations (RICs), pay higher tax rates on dividends in certain developed countries when compared to ERISA CITs.i For example:

  • Japan, one of the largest developed markets representing approximately 15.88% of the MSCI ACWI ex US IMI Index, had a dividend yield of 2.10% in 2021.ii iii
  • The MSCI ACWI ex US IMI Index assumes Japanese dividends were taxed at a rate of 27.5%, which represents the highest possible tax rate, reducing the dividend yield above by that amount.
  • Mutual fund investors are able to reduce the tax rate to 10% whereas ERISA CITs are able to reduce the tax rate to zero because of different treatments under the existing tax treaty.
  • As such, an ERISA CIT retains the entire Japanese dividend yield of 2.10% whereas the dividend yield to a mutual fund is reduced by 10% to 1.89% (a difference of 21 basis points or bps). Applied to Japan’s weight in the index (15.88%), the mutual fund investor pays 3 bps in taxes vs. an ERISA CIT investor.

ERISA CITs are afforded a tax rate of zero in ten countries, which represent 46.5% of the MSCI ACWI ex US IMI Index. Mutual funds pay a tax rate of 10–15% in these same countries. Based on 2021 dividend yields, this difference in tax rates equates to a cost advantage of 14 bps for an ERISA CIT investor over a mutual fund investor.

Figure 1: Meaningful CIT Tax Benefits Gained in the MSCI ACWI ex US IMI Index

Country 2021 Dividend Yield (%) ERISA CIT Tax Rate (%) Mutual Fund Tax Rate (%) Weight of MSCI ACWI x US IMI Impact (Yield Tax Diff Weight) (bps)

Japan

2.1

0

10

15.9

3

Canada

2.7

0

15

6.7

3

Switzerland

2.6

0

15

5.6

2

Germany

2.3

0

15

5.5

2

Sweden

3.1

0

15

2.7

1

Australia

3.9

0

15

4.6

1

Netherlands

1.6

0

15

2.6

1

Spain

1.7

0

15

1.5

0

Finland

2.8

0

15

0.72

0

Belgium

2.2

0

15

0.66

0

MSCI ACWI x US IMI

 

 

 

46.5

+14

Source: MSCI Index Data, published ERISA and RIC Tax Rates, as of Date 12/31/2021.

Said differently, assuming your plan has $100 million in an index fund benchmarked to the MSCI ACWI ex US IMI Index, the decision to utilize a mutual fund over a CIT can cost your employees $140,000 in plan returns. The difference becomes starker when considering CIT indices that include only developed countries where the tax benefit is concentrated.

Figure 2: CIT Tax Benefits Translate to Positive Performance

Year 2021
Index

Gross Dividend Yield (5)

ERISA – Index Tax Diff (%)

Mutual Fund – Index Tax Diff (%)

ERISA – Mutual Fund Tax Benefit (%)

MSCI WORLD x US

2.71

0.42

0.22

.20

MSCI ACWI x US IMI

2.03

0.28

0.15

0.14

MSCI ACWI

1.70

0.36

0.30

0.06

Source: MSCI Index Data, published ERISA and RIC Tax Rates, as of Date 12/31/2021.

Next Steps

As a plan sponsor, you should have insight into whether your workplace retirement savings plan is invested in a CIT or mutual fund structure. But buyer beware — some CITs offered by some of the industry’s most widely used managers invest in underlying mutual funds, meaning the investments may not be eligible to deliver the CIT tax benefits described above.

Figure 3: CIT Direct Investment vs. Fund of Funds

Moving your international equity allocation from a mutual fund to a CIT provides an easy opportunity to reduce your plan’s tax bill and increase your employees’ retirement savings.

Figure 4: State Street’s International Equity Collective Trust Offerings

Asset Class

Fund Name

Index

Total Expense Ratio

Investment Minimum

Developed ex-US

State Street World Developed ex-US Index Fund

MSCI World x US

3.5 bps

(0.035%)

$10 million

Developed ex-US + Emerging

State Street Global All Cap Equity ex-US Index Fund

MSCI ACWI x US IMI

4.5 bps

(0.045%)

$10 million

Source: State Street Global Advisors. Total expense ratios pertain to securities lending share classes. As of Date 12/31/2021.