Tax planning is an essential component in choosing investments in a taxable account. That’s because what you owe the government on investment earnings reduces your return and increases the risk of not meeting your goals.
ETFs are typically tax-efficient, allowing investors to keep more of their earnings. When you evaluate investments, the return you anticipate and the risks you might face typically deserve the greatest scrutiny.
How is ETFs tax efficient?
A low turnover and insulation from other shareholders’ actions are significant factors in determining how tax-efficient an ETF is. Unlike actively traded mutual funds, index funds and most conventional ETFs are tax-efficient because they sell assets only when the components of their underlying indexes change. Unfortunately, this limited turnover means they make less profit for their shareholders.
On average, an ETF or index mutual fund linked to the S&P500 sells shares in 22 companies in its portfolio each year to make way for a comparable number added to the index. This means an annual turnover of about 4.4% of its portfolio. In contrast, actively traded equity funds have turnover rates close to 100%. A stock exchange is a place where investors can buy and sell ETF shares with other investors. So, to satisfy investor redemptions, the ETF manager is spared from liquidating holdings and realizing financial gains. You can choose when to sell an ETF investment, which makes it simpler to avoid paying the higher short-term capital gains tax rates.
Which ETFs are most tax-efficient?
In recent years, ETFs have become very popular, in part due to their capacity to reduce taxable capital gains. Not all ETFs are tax-efficient, but widely diversified base stock ETFs can minimize capital gains distributions due to their extremely low turnover and the ETF structure.
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Capital gains on ETFs holding gold or other precious metals are taxed as ordinary income, although there is a rate cap of 28% on long-term gains. When the ETF is a partnership, you may owe taxes on unrealized gains each year, and when you sell, 40% of any gains are considered short-term and taxed accordingly, even if you have held the ETF for more than a year.
The majority of Currency ETFs are grantor trusts. This indicates that the ETF shareholder has a tax obligation due to the trust’s profit, which is taxed as ordinary income. Regardless of how long the ETF held the contracts, gains and losses on the futures included in the ETF are regarded for tax purposes as 60% long-term and 40% short-term.
ETF tax efficiency
There are smart ways to control the impact of taxes. One strategy is to hold investments that tend to generate higher taxes in tax-deferred or tax-free accounts. You might consider offsetting capital gains in taxable accounts by taking capital losses. And, also in taxable accounts, you can choose tax-efficient investments, which means they cost you less at tax time than other investment choices do.
For example, individual stocks and index-based ETFs, as a group, are more tax-efficient than:
• Corporate, US Treasury, and most federal agency bonds and the mutual funds invested in them. That’s because federal taxes on qualifying dividends and long-term capital gains are calculated at a lower rate than interest income is. (Municipal bond interest is generally exempt from federal and sometimes state income taxes. )
• Real estate investment trusts (REITs). Income distributions from REITs are generally taxed at the same rate as ordinary income rather than at the long-term
capital gains rate that applies to qualifying dividends.
• Actively managed mutual funds. Active managers tend to trade securities frequently to beat their benchmarks. Those trades, the timing of which you can’t control, result in taxable capital gains distributions. Often, they are short-term gains that are taxed at the same rate as ordinary income.
What’s the difference between ETF and Mutual Funds?
In general, though, ETFs are more tax efficient than either active or passive mutual funds because of how the two types of pooled investments are structured. The first difference is that, with mutual funds, other investors’ actions can significantly impact your tax liability. This isn’t the case with ETFs.
For example, suppose your fellow mutual fund shareholders redeem many shares. In that case, the fund will probably have to liquidate a portion of its investment portfolio to generate the cash it needs to back those shares. At least some of these sales are likely to produce capital gains, and those gains will typically be passed on to you as taxable income.
In contrast, an ETF doesn’t redeem shares that shareholders want to sell, so it doesn’t have to sell holdings to meet investor demand. This means the ETF has few capital gains to pass on to shareholders. The other difference is the impact of the unique creation and redemption process that characterizes ETFs.
Actively managed mutual funds may realize long-term capital gains by selling securities with a low-cost basis that have significantly increased in value over an extended period — perhaps to boost the fund’s return or because the manager anticipates a falling price. Shareholders owe tax on the gains allocated to their accounts.
Building Tax Efficient ETF Portfolio by Inna Rosputnia
*The information provided on this page is not intended to be tax advice. You should always consult your tax professional about the impact of investment decisions you are considering on your tax liabilities.
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