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Investment experts say investors who own exchange-traded funds often avoid taxes imposed by investors who own mutual funds, which are generally less tax-efficient.
ETFs and mutual funds are baskets of stocks, bonds, and other financial assets overseen by professional money managers. But ETFs have a different legal structure, giving them “tax magic that mutual funds can't match,” said Brian Armor, director of North American passive strategies research at Morningstar and editor of the ETF Investor newsletter. says. I wrote this year.
The tax savings relate to annual capital gain distributions within the fund.
Capital gains tax is levied on investment profits.
Fund managers can generate such taxes within a fund when they buy or sell securities. The tax is then passed on to all fund shareholders, who are responsible for paying the tax. Even if you reinvest Those distributions.
The tax benefit of ETFs comes from “in-kind creation and redemption,” which essentially allows many ETFs to be traded tax-free, experts explain. (ETF's spot trading mechanism is somewhat complex. Broadly speaking, included Large institutional investors, known as “authorized participants,” who create or redeem ETF shares directly with ETF providers. )
In general, it is stock funds that have the most significant tax benefits.
For example, more than 60% of equity mutual funds distributed capital gains in 2023, according to Morningstar. This applies to just 4% of ETFs.
Morningstar: Less than 4% of ETFs expected to distribute capital gains in 2024 estimate. Such data is not yet available for mutual funds.
Importantly, this tax benefit only concerns investors who hold funds in taxable accounts, experts say.
Experts say this is a moot point for investors in retirement accounts, such as 401(k) plans and individual retirement accounts, which already have tax benefits.
Charlie Fitzgerald III, a certified financial planner based in Orlando, Fla., and a founding member of Moisand Fitzgerald Tamayo, says this tax benefit “really helps non-IRA accounts more than anything else. “It will become,” he says.
“It's clear that there are tax savings you can't achieve with standard mutual funds,” he said.
But experts say ETFs don't necessarily have tax benefits.
For example, certain ETF holdings may not benefit from physical trading, Armor said.
Examples include physical products as well as derivatives such as swaps, futures contracts, currency forward contracts and certain option contracts, he said.
Additionally, certain countries, such as Brazil, China, India, South Korea and Taiwan, may treat in-kind redemptions of securities domiciled in those countries as taxable, he said.
