ETF tax efficiency: The advantages over mutual funds

FeaturedMoney

Written by:

There’s no denying that exchange-traded funds (ETFs) are popular. According to the New York Stock Exchange’s most recent quarterly ETF report, as of December 31, 2020, there were 2,391 ETF listed in the U.S. Those funds hold a total of $5.49 trillion in assets, with an average of $111.5 billion transactional daily value.

Investors primarily turn to ETFs because of the returns. The average annual 10-year return for the benchmark SPDR S&P 500 ETF stands at above 14% at the end of 2020. (That said, as always past performance is not a guarantee of future success.)

There is another major benefit of ETFs — they’re a good tax-limitation tool.

In a 2019 Morningstar report on investment funds and taxes, analysts conclude that 84% of all ETF portfolio assets were steered toward specially-focused funds that closely follow market-cap-weighted indexes. Such funds historically have low investor turnover, which in turn curbs capital gains and fund distributions, and thus reduces excess “taxable events.”

Image Credit: Artystarty/ iStock.

ETFs & Mutual Funds: How They Differ

ETF tax efficiency: The advantages over mutual funds

When it comes to understanding ETFs vs mutual funds, it’s often best to start with a simple explanation for each.

Both mutual funds and ETFs invest in a group or “basket” of underlying stocks, bonds, commodities, and other financial assets, on behalf of fund shareholders. But ETFs trade on a daily basis much like stocks and bonds. Mutual funds do not.

Mutual funds offer investors a menu of various share classes where they can invest their money. Given the wider assets selection options available, a mutual fund investor may see more fund fees to compensate for that expanded menu. Given their low trading structure, ETF fees are usually lower than mutual funds, resulting in a lower expense ratio.

Image Credit: DepositPhotos.com.

ETF Tax Advantages Over Mutual Funds

ETF tax efficiency: The advantages over mutual funds

Tax-wise, The IRS treats ETFs and mutual funds the same. When either fund model sells securities that have appreciated in value, it creates a capital gain — or capital appreciation on the investment

https://www.sofi.com/learn/content/capital-appreciation-on-investments/

—  which is taxable under U.S. law.

ETF fund managers make trades for a variety of reasons. For example, an asset can be bought and sold for strategic reasons (i.e. to properly allocate assets or to avoid “style drift” when a fund slides away from its target strategy.) Trades also must be made upon shareholder redemptions—when they redeem some or all of the assets they’ve invested in the fund.

The more trades made by ETF fund managers, the more taxable events occur. Consequently, for fund managers and investors, the goal is to find ways to keep those taxes from accumulating.

An ETF’s structure can help curb the negative impact of taxes, in the following ways.

Image Credit: Bet_Noire / iStock.

1. Lower Capital Gains Impact

ETF tax efficiency: The advantages over mutual funds

Since the IRS considers capital gains a taxable event, a major goal with any fund investment is to reduce the impact of capital gain payouts to shareholders at year end.

ETFs typically accumulate fewer capital gains than mutual funds. When a mutual fund has to redeem assets back to shareholders, it must sell assets to create the money needed to pay out those redemptions, resulting in capital gains.

But when an ETF shareholder wants to sell shares, they can easily do so by trading the ETF to another investor — just like a stock transaction. That, in turn, creates no capital gains impact for the ETF — and adds a major tax advantage for ETF investors.

Image Credit: TriggerPhoto/istockphoto.

2. Index Tracking Tax Benefits

ETF tax efficiency: The advantages over mutual funds

Since many ETFs are structured to track a particular index, trades are made only when there are changes in the underlying index (like when the S&P 500 or the Russell 2000 index experience significant fluctuations that require some ETF stabilization). Fewer transactions generally means lower taxes.

Image Credit: DepositPhotos.com.

3. The Use of “Creation Units”

ETF tax efficiency: The advantages over mutual funds

ETFs are built to trade differently than mutual funds. With ETFs, fund managers can leverage so-called “creation units” — blocks of shares — to buy and sell fund securities. These units enable fund managers to buy or sell assets collectively, instead of individually. That means fewer trades and fewer taxable trade execution events.

Image Credit: Алексей Белозерский/ iStock.

Downsides of ETFs and Taxes

ETF tax efficiency: The advantages over mutual funds

Though ETF tax efficiency is generally better than that of mutual funds, that doesn’t mean ETFs come with no tax risks. There are a few taxable events that bear watching for investors.

Image Credit: Helloquence.

1. Distributions and dividends

ETF tax efficiency: The advantages over mutual funds

Just like any investment vehicle, ETFs can come with regular distributions and dividends, which are usually taxable.

Image Credit: ipopba/ iStock.

2. Increased Trade Activity on Actively Managed Funds

ETF tax efficiency: The advantages over mutual funds

Though most ETFs simply follow an investment index, there are some actively managed ETFs. With actively-managed funds, more trades are made, which may lead directly to a more onerous tax bill.

Image Credit: Pinkypills / iStock.

3. High Trading Costs

ETF tax efficiency: The advantages over mutual funds

Since ETFs are traded like stocks, the fees that come with buying and selling ETF assets usually trigger trading costs that are akin to trading stocks — and those fees can be high.

Historically, brokerage trading fees are among the highest fees in the investment industry, which isn’t great news for ETF investors. Even if investors do save on taxes, those savings can potentially be mitigated or even wiped out by high ETF trading costs.

Image Credit: Lazy_Bear / iStock.

The Takeaway

ETF tax efficiency: The advantages over mutual funds

Exchange traded funds offer ample potential tax benefits to savings-minded investors, especially in key areas like capital gains, expense ratios, redemptions, and trading frequency.

Learn more:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

SoFi InvestThe information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA  SIPC  . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or pre-qualification for any loan product offered by SoFi Lending Corp and/or its affiliates.Fund FeesIf you invest in Exchange Traded Funds (ETFs) through SoFi Invest (either by buying them yourself or via investing in SoFi Invest’s automated investments, formerly SoFi Wealth), these funds will have their own management fees. These fees are not paid directly by you, but rather by the fund itself. these fees do reduce the fund’s returns.. Check out each fund’s prospectus for details. SoFi Invest does not receive sales commissions, 12b-1 fees, or other fees from ETFs for investing such funds on behalf of advisory clients, though if SoFi Invest creates its own funds, it could earn management fees there.External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Image Credit: DepositPhotos.com.


ETF tax efficiency: The advantages over mutual funds

Brian O'Connell

Brian O'Connell is a freelance writer and contributor at Experian.com.

Leave a Reply

Your email address will not be published.