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Investment experts say investors who hold exchange-traded funds can often escape the taxes incurred by investors who hold mutual funds, which are often less tax efficient.
ETFs and mutual funds are baskets of stocks, bonds, and other financial assets overseen by professional money managers. But they have different legal structures, giving ETFs “tax magic that mutual funds can’t match,” said Bryan Armor, director of research for passive strategies in North America and editor of Morningstar’s ETF investor newsletter. Wrote This year.
Tax savings are associated with annual capital gains distributions within the fund.
Capital gains tax is levied on investment profits.
Fund managers can incur such taxes within the fund when they buy and sell securities. The tax will then be passed on to all fund shareholders who owe a tax bill Even if they reinvest those distributions.
Experts explain that the tax advantages of ETFs are achieved through “physical creation and redemption,” which essentially provides tax-free transactions for many ETFs. (The physical trading mechanism of ETFs is somewhat complex. From a high level, it involving Large institutional investors, known as “authorized participants,” work directly with the ETF provider to create or redeem ETF shares.
They say the tax advantages are often most pronounced for equity funds.
For example, more than 60% of stock mutual funds will distribute capital gains in 2023, according to Morningstar. Only 4% of ETFs are like this.
Morningstar expects less than 4% of ETFs to distribute capital gains in 2024 estimate. Such data is not yet available from mutual funds.
Importantly, experts say, this tax benefit only applies to investors who hold their money in taxable accounts.
Experts say this is a moot point for retirement account investors who have 401(k) plans or individual retirement accounts because those accounts already offer tax benefits.
The tax benefits “really help non-IRA accounts the most,” said Charlie Fitzgerald III, a certified financial planner in Orlando, Fla., and a founding member of Moisand Fitzgerald Tamayo.
“There’s no doubt you’re going to get tax efficiencies that you just can’t get with standard mutual funds,” he said.
However, experts say ETFs don’t always have tax advantages.
Some ETF holdings, for example, may not benefit from physical trading, Armor said.
Examples include physical commodities, as well as derivatives such as swaps, futures contracts, currency forwards and certain options contracts, he said.
Additionally, he said certain countries, such as Brazil, China, India, South Korea and Taiwan, may treat physical redemptions of securities within those countries as taxable events.
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