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.”
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ETFs & Mutual Funds: How They Differ
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.
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ETF Tax 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
— 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.
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1. Lower Capital Gains Impact
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.
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2. Index Tracking Tax Benefits
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.
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3. The Use of “Creation Units”
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.
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Downsides of ETFs and Taxes
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.
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1. Distributions and dividends
Just like any investment vehicle, ETFs can come with regular distributions and dividends, which are usually taxable.
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2. Increased Trade Activity on Actively Managed Funds
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3. High Trading Costs
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.
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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.
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