ETFs (exchange-traded funds) are now a global phenomenon and have a well-earned reputation for being tax-efficient investments. While investors have flocked to ETFs for a variety of reasons, including low prices, broad diversification, and ease of use, tax efficiency is one of the biggest advantages for many ETF investors.
There are several factors that make ETFs highly tax-efficient. In the US, for example, they are becoming more popular than mutual funds due to the fact that they distribute smaller and fewer capital gains.
However, investors should understand that while ETFs are considered tax-efficient, it doesn’t mean they’re tax-free. This article explores ETF tax efficiency, and everything investors need to understand about how their ETF investments handle taxes.
- Factors that contribute to ETF tax-efficiency
- Capital Gains Tax
- Low turnover and index funds
- The anatomy of an ETF
- So, how are ETFs taxed?
- Dividends and interest
- Precious metal funds
- Commodity ETFs and futures
- What should investors be aware of?
- Conclusion
Factors that contribute to ETF tax-efficiency
Several key factors contribute to ETF tax efficiency, including reduced capital gains, low turnover, and the overall anatomy of ETFs.
First, let’s consider capital gains.
Capital Gains Tax
Capital gains is a tax on the profit you make when you sell (or ‘dispose of’) something (e.g., an ‘asset’) that has increased in value, so when an ETF or mutual fund owns securities that have risen in value, and sells them for whatever reason, capital gains will be distributed.
These sales can be the consequence of the fund selling securities as a strategic move, as part of a rebalancing exercise, or to meet shareholder redemptions. If a fund earns capital gains, it is required by law to pay them out to shareholders at the end of the year.
According to ETF.com, the typical emerging markets equity mutual fund paid out 6.46% of their net asset value (NAV) to owners in capital gains each year. By comparison, ETFs performed significantly better, with the average emerging market ETF paying out 0.01% of its NAV as capital gains over the same time frame.
But, why?
Low turnover and index funds
The reason ETFs can distribute fewer capital gains is that a lot of ETFs are index funds and passively track market-capitalization-weighted indexes. ETFs largely owe their tax-efficient reputation to this, as they have much lower turnover than actively managed mutual funds, and thus accumulate significantly smaller capital gains.
Low-turnover methods are naturally tax-efficient, and effective tracking of such indexes can often be performed with minimal portfolio turnover.
The anatomy of an ETF
Furthermore, the actual anatomy of an ETF, and the subsequent process of how they are produced and redeemed, is designed to be tax efficient.
ETFs trade on an exchange in the same way that ordinary stocks do, so most ETF trading takes place on the secondary market between investors, with no influence on the underlying securities.
When mutual fund investors want to request a withdrawal, the mutual fund has to sell securities to raise funds to cover the withdrawal. However, when an investor wishes to sell an ETF, they can simply sell it like a stock to another investor. For the ETF, there is no bother or hassle, and no capital gains action is required.
So, how are ETFs taxed?
Investors should be aware that, while ETFs are considered tax-efficient, they may distribute capital gains periodically. The chief objective of index-based ETFs is to closely replicate the target index. Maintaining tax efficiency is another key goal for portfolio managers, but it might only be one of several secondary objectives that also include minimizing overall transaction costs.
When investors sell their ETF shares, they may make a taxable profit or loss. Additionally, ETFs may also engage in taxable transactions when a target index is rebalanced and specific stocks are added to or withdrawn from it.
Furthermore, a thorough examination of how different countries and tax codes treat different types of ETFs in the market is crucial, and will often reveal further tax intricacies – concerning, for example, dividends, interest, and more.
Here are some examples of how the US treats different factors associated with ETF taxing, but every country is different and it is essential to do your background research.
Dividends and interest
Distribution ETFs (or in other words, ETFs that carry dividend-paying assets) will typically distribute those dividends to investors around once a year, or more regularly. Additionally, ETFs that hold interest-paying bonds will often distribute that interest to investors on a regular basis.
In the UK, for example, ETF dividends distributed to residents are usually taxed as foreign dividends and are usually liable to income tax, as dividends are considered income to investors.
In the US, both interest payments and dividends from ETFs are taxed by the IRS in the same way as income from the underlying stocks or bonds are.
Precious metal funds
ETFs that give you exposure to precious metals, like gold, for instance, may face their own set of tax rules. An investment in a precious metals ETF, for example, could be treated the same as an investment in the actual metal itself, which is treated as a collectible for tax reasons.
The highest long-term capital gains rate you’ll pay on collectibles is higher than the rate you’d pay on an equity ETF. On the other hand, short-term gains on collectibles are taxed like ordinary income.
This isn’t to say you shouldn’t use precious metals to diversify your portfolio. To avoid unpleasant surprises, you should be informed of the various tax treatment options.
Commodity ETFs and futures
Commodity ETFs, such as those investing in corn and oil, invest in futures contracts because holding the physical commodity is often unfeasible.
Futures have their own unique tax implications, and depending on whether the futures contracts are more expensive (known as “contango”) or less expensive (known as “backwardation”) than the commodity’s market price, using futures can have a significant impact on the portfolio’s performance.
What should investors be aware of?
The bottom line is: The majority of ETFs are highly tax-efficient, but they are not completely tax-free. Many ETFs track an index and ultimately, due to low turnover, distribute fewer capital gains than other traditional fund structures. However, it is absolutely crucial to pay attention to different tax codes.
For instance, you may find in the UK – since most people pay their highest marginal rates on income tax – that ETFs are best shielded in investors’ ISAs and SIPPs (Self-Invested Personal Pensions). This is because interest, dividends, and capital gains earned in ISAs and SIPPs are not taxable.
However, capital gains distributions in the US will have the least impact on investors in tax-advantaged accounts like IRAs and retirement plans.
Conclusion
As the ETF industry grows and expands into new markets – developing increasingly innovative and complex products – the tax implications are becoming slightly more complicated. Ultimately, there is no way to get around paying taxes when profit is involved.
However, like with so many things in life, it all comes down to employing the appropriate method at the appropriate time. ETFs are a superior choice for investors who want to invest for the long-haul by potentially minimizing tax implications, and allowing them to put more money toward their goals. And, naturally, because everyone’s circumstances are unique, it is always a good idea to speak to a tax advisor who can help you figure out what’s best for you.
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