When you evaluate investments, the return you anticipate and the risks you might face typically deserve the greatest scrutiny. But how much attention should you pay to the taxes that the investment could generate if owned it or sold it at a profit?
In fact, 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.
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. In taxable accounts, you might consider offsetting capital gains by taking capital losses. And, also in taxable accounts, you can choose investments that are tax-efficient, 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 that invest 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 in an effort 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.
Unlike actively traded mutual funds, index funds and most conventional ETFs are tax-efficient because they sell holdings only when the components of their underlying indexes change. This limited turnover means realize fewer gains to pass on to their shareholders.
On average, an ETF or index mutual fund that is linked to the S&P500 sells shares in 22 companies in its portfolio each year to make way for a comparable number that has been 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%.
But not all ETFs are tax-efficient 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.
ETF vs mutual funds
In general, though, ETFs are more tax efficient than either active or passive mutual funds because of the way the two types of pooled investments are structured. The first difference is that, with mutual funds, the actions of other investors can have a significant impact on your tax liability. This isn’t the case with ETFs.
For example, if your fellow mutual fund shareholders redeem a large number of shares, 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 if 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.
If you have been a shareholder for most of the holding period, the tax may be offset by the increased value in your account due to the growth in the security’s value. But if you have purchased shares recently, you are being taxed on growth from which you’ve derived no benefit. Those are known as phantom gains.
In contrast, as ETFs continually exchange the securities in their portfolio for fund shares and create new fund shares in exchange for securities, they regularly return the securities with the lowest cost basis and receive securities with a higher cost basis. As a result, when securities are sold because of changes to the underlying index, there are smaller profits and more limited capital gains than a mutual fund would likely produce with the same transaction.
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.
Wishing you a great week!
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