ETFs & Tax Efficiency: What Investors Need To Know

(Video length 00:10:15)

It is the capital gains distributions season and many mutual fund investors may have to pay capital gains taxes on their investments even if they had “unrealized” losses on some of those investments.

Mutual funds are infamous for causing tax headaches to unsuspecting investors. Many investors do not know that ETFs are very tax efficient especially compared with mutual funds. Since most ETFs track well-known market indexes, they usually experience lower turnover compared with actively managed funds and thus create fewer “taxable events” that result in tax liabilities.

For example, the most popular ETF—the SPDR S&P 500 (SPY  - Free Report) —usually has an annual turnover rate of less than 4%.

But more importantly, ETFs are generally more tax efficient due to the way they are structured. In the case of ETFs, creation and redemption are “in-kind” transactions and thus there are no tax implications.

On the other hand, for mutual funds, creations and redemptions are cash transactions that result in tax liabilities. As many mutual funds have sold securities this year to raise cash to meet investor redemptions, they have created capital gains for the shareholders.

Per iShares, over the last 5 years, 55% of mutual funds paid out a capital gain distribution, versus about 10% of ETFs.

However, not all ETFs are tax efficient. Bond ETFs often require frequent rebalancing to maintain their target duration or maturity. Thus, bond ETFs have to pay out capital gains at times but usually, capital gains have been minuscule for bond ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG - Free Report) and Vanguard Total Bond Market ETF (BND - Free Report) in the past few years.

Inverse and leveraged ETFs like Direxion Daily S&P 500 Bull 3X Shares (SPXL) are not very tax efficient as they reset daily and may realize significant short-term capital gains.

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