Investors are attracted to exchange traded funds for several reasons. They are easy to buy and sell, have lower expense ratios than mutual funds and ETFs are also touted for their tax-efficiency.
ETFs have more favorable tax treatments than other index-style funds due to their different structure. As passively managed portfolios, ETFs realize fewer capital gains than actively managed funds. ETFs are also created and redeemed different than a mutual fund. [ Bond ETFs and Taxes ]
For example,if an investor wants to redeem $50,000 from a mutual fund, so to pay that investor, the fund must sell $50,000 worth of stock. If appreciated, stocks are sold to free up the cash, the fund captures the capital gain, and this is distributed to shareholders before year end. Shareholders in turn pay the taxes for the turnover within the fund. In contrast, if an ETF shareholder wants to redeem $50,000, the ETF does not sell any stock in the portfolio. Rather, it offers shareholders “in-kind” redemptions which help stave off any capital gains taxes.
Dan Caplinger for The Motley Fool explains that as far as capital gains are concerned, ETFs are more tax efficient than mutual funds. ETFs do not liquidate big positions in stocks that have large gains. The only time a stock is replaced in an ETF is if the entire index is changed. A mutual fund, on the other hand, will pass on capital gains taxes to all shareholders whether or not the individual themselves sold shares. [ ETFs and Tax-Loss Harvesting ]
For a tax strategy, consider the long term capital gains rate versus a short term capital loss. As a one-year time period of holding an ETF is near, consider selling those with any losses before the one year mark to use the short term capital loss rate. Any ETFs with a gain should be held past the one year mark, which will help to apply the lower long term capital gains rate. [ Advisors Need to Brush up on ETF Education ]
Tisha Guerrero contributed to this article.