Capital Gain Tax Hike To Power Inflows: 5 ETFs To Win

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Given that the markets are skyrocketing, the ETF industry is also booming, breaching new records in terms of inflows. This is especially true as investors have poured more cash into ETFs, breaking the 2020 records. Within four months of this year, the ETF pulled in a record $320.3 billion in fresh capital, well above last year’s $121.1 billion.

The solid trend is likely to continue, as President Joe Biden’s tax hike plan will lure more investors to the ETFs. Biden has proposed to increase the top rate on long-term capital gains to 39.6% from 20% to those making more than $1 million a year. These higher taxes would apply to taxable brokerage accounts, but not tax-deferred accounts, which include 401(k) plans. Additionally, Biden seeks to raise the top rate on income taxes to 39.6% from 37%.

Per Bloomberg, ETFs’ tax efficiency characteristic could be a boon for those looking at a higher tax bill. This would accelerate the ongoing shift that has shifted hundreds of billions of dollars from mutual funds to ETFs.

How Are ETFs Tax Efficient?

The ETFs are more tax-efficient than mutual funds. This is because mutual fund managers need to sell securities to raise cash for redemptions in case an investor exits the fund, which triggers a taxable event for all investors. On the other hand, ETFs follow an “in-kind” creation and redemption process where ETF issuers exchange shares for baskets of underlying securities, which do not trigger a taxable event.

December study by researchers at Villanova and Lehigh universities found out that over the past five years, ETFs have averaged a tax burden 0.92% lower than the active mutual funds. Moreover, particularly for high net-worth investors, tax considerations have outweighed both performance and fees as the primary driver of inflows to ETFs from the active mutual funds, the findings showed. Further, passively managed ETFs are more tax-efficient than actively managed funds.

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