The Advantages of Exchange-Traded Funds: A Tax Perspective
Many investment experts suggest that Exchange-Traded Funds (ETFs), as compared to mutual funds, offer a more tax-efficient way for investors to manage their portfolios. Both ETFs and mutual funds are professionally managed collections of stocks, bonds, and other financial assets. However, the legal structure of ETFs gives them a unique advantage when it comes to taxation.
Bryan Armour, North America’s Director of Passive Strategies Research and editor of Morningstar’s ETFInvestor newsletter, refers to this as the “tax magic” of ETFs. This magic lies in the way annual capital gains distributions within the funds are taxed. Capital gains taxes are usually due on any profits made from investments. These taxes can be generated within a fund when portfolio managers buy and sell securities. In turn, these taxes are passed on to all the fund’s shareholders, who are then liable to pay them, even if they reinvest the profits.
ETFs, however, have a unique mechanism known as “in-kind creations and redemptions” that allows for tax-free trades in many cases. This process involves large institutional investors, referred to as “authorized participants,” who create or redeem ETF shares directly with the ETF provider. This tax advantage is especially noticeable in stock funds.
As per Morningstar data, over 60% of stock mutual funds distributed capital gains in 2023, compared to only 4% of ETFs. Less than 4% of ETFs are projected to distribute capital gains in 2024, though data for mutual funds is not available yet.
However, it’s important to note that this tax advantage is only relevant for those who hold funds in taxable accounts, and not for those with retirement accounts like a 401(k) plan or an individual retirement account which already come with tax benefits. According to Charlie Fitzgerald III, a certified financial planner, the tax advantage of ETFs is particularly beneficial for non-IRA accounts. He believes that ETFs can achieve a level of tax efficiency that standard mutual funds cannot.
Despite this, there are instances where ETFs do not have a tax advantage. For instance, certain ETF holdings, such as physical commodities and derivatives like swaps, futures contracts, currency forwards, and certain options contracts, may not benefit from in-kind transactions. In addition, some countries such as Brazil, China, India, South Korea, and Taiwan, may treat in-kind redemptions of securities domiciled in those countries as taxable events.
In conclusion, while ETFs offer several advantages over mutual funds, including potential tax benefits, these benefits may not be applicable in all cases. Therefore, it’s important for potential investors to thoroughly understand these nuances before making a decision.
