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Experts say investors can typically reduce tax losses in their portfolios by using exchange-traded funds rather than mutual funds.
“ETFs have 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. states. I wrote At the beginning of this year.
However, certain investments can benefit from so-called magic more than others.
Tax savings are meaningless in retirement accounts.
The tax savings from ETFs are typically greatest for investors in taxable brokerage accounts.
Experts say these are controversial for retirement investors, such as those who save in 401(k) plans and individual retirement accounts. Retirement accounts are already tax-advantaged, and contributions are increasingly tax-free, experts say. This means that ETFs and mutual funds are on a level playing field compared to taxes.
Charlie Fitzgerald III, a certified financial planner based in Orlando, Fla., and a founding member of Moisand Fitzgerald Tamayo, says this tax benefit is “the biggest help for non-IRA accounts of all time.” “It will become,” he says.
“It's clear that there are tax savings you can't achieve with standard mutual funds,” he said.
“Main usage examples” of ETFs
Mutual funds are generally less tax efficient than ETFs. Capital gains taxes incurred within the fund.
Taxpayers who sell investments for capital gains (i.e., profits) are likely familiar with the concept of paying taxes on that gain.
The same concept applies to mutual funds. Mutual fund managers generate capital gains when they sell their holdings within the fund. Management distributes these capital gains to investors each year. They distribute it equally to all shareholders, who then pay tax at their respective income tax rates.
However, ETF managers can typically avoid capital gains taxes due to their unique structure.
As a result, asset classes that generate large capital gains relative to total returns are “primary use cases for ETFs,” Armor told CNBC. (This discussion applies only to intra-fund purchases and sales; investors who sell an ETF for a profit may still be liable for capital gains taxes.)
Why U.S. stocks “almost always” benefit from ETFs
Experts say U.S. stock mutual funds tend to generate the most capital gains compared to other asset classes.
In the five-year period from 2019 to 2023, about 70% of U.S. equity mutual funds initiated capital gains, Armor said, citing Morningstar data. That applies to less than 10% of U.S. stock ETFs, he said.
“It's almost always better to manage your stock portfolio in ETFs rather than mutual funds” in non-retirement accounts, Armor said.
According to Morningstar, U.S. growth stocks, a subcategory of stocks, will account for more than 95% of their total returns over the five-year period ending in September 2024 through capital gains. This makes them “the biggest beneficiary of the ETF's tax efficiency,” Armor said.
“Core” large-cap and small-cap stocks also “benefited significantly,” with about 85% to 90% of returns coming from capital gains, Armor said.
About 25% to 30% of value stocks' returns come from dividends, which are taxed differently than capital gains within the ETF, making them the “least profitable” of the U.S. stocks in the ETF, Armor said. said.
“Yet, they still make a big profit,” he says.
ETF and mutual fund dividends taxed as well. ETF dividends are taxed depending on how long the investor held the fund.
Fitzgerald said actively managed equity funds also generally lend themselves to ETF structures.
He said active managers buy and sell positions frequently to beat the market, so they tend to distribute more capital gains than managers who passively track stock indexes.
But there are also examples of passively managed funds, such as so-called strategic beta funds, that trade frequently, Armor said.
The advantages of bonds are small
Armor said ETFs typically cannot “wash away” tax liabilities associated with currency hedging, futures and options.
In addition, each country's tax law could reduce tax benefits for international equity ETFs that invest in Brazil, India, South Korea and Taiwan, for example, he said.
Bond ETFs have a smaller advantage over mutual funds, Armor said. Because bond funds' generous returns typically income Not capital gains (i.e. bond payments), he said.
Fitzgerald says he prefers holding bonds in mutual funds rather than ETFs.
But his reasoning has nothing to do with taxes.
During periods of stock market volatility, such as when unexpected events cause a lot of fear selling and stock prices fall, Mr. Fitzgerald sells bonds to buy stocks at a discount for his clients. There are many.
However, during such periods, he found that bond ETF prices tended to diverge more from the net asset value of their underlying assets (compared to mutual funds).
He says bond ETFs often sell at a discount compared to similar bond mutual funds. Selling the bond position for a smaller amount would somewhat dilute the overall strategy's gains, he said.
