One of the most important benefits of an exchange-traded fund (ETF) is the tax efficiency it carries over a mutual fund. To understand why ETFs are more tax-efficient than mutual funds, you need to understand two things: capital gains tax and the structure of these two different financial products.
Capital Gains Tax
When you sell an asset for a profit, the government wants its share of the sale. The tax on this profit is known as capital gains tax. If you make a profit, the government makes a profit too.
However, not all profits are treated the same way by the Internal Revenue Service (IRS). The key factor in the capital gains tax rate is the holding period of the security. If you hold a stock for one year or less before selling it for a profit, the profit will be taxed at your ordinary income tax rate. If you hold the stock for more than a year, your profits are subject to the long-term capital gains tax rate.
More Frequent Trading of Mutual Funds
Most mutual funds are actively traded. Every time someone buys into the fund, the fund manager uses that money to purchase more shares. Every time someone sells some of their mutual fund shares, the fund manager must sell assets to gain the cash needed to pay the person for the shares they are selling.
Each time this happens, and securities are sold for a profit, capital gains taxes must be paid. Over time, these recurring taxes can add up significantly. Investors cannot choose which stocks are sold, so they have no control over whether gains are short-term or long-term.
ETFs operate quite differently. Many popular index ETFs are passively managed. The underlying assets of an ETF are re-evaluated less frequently, such as once a quarter. When those assets are re-evaluated, they are rebalanced to ensure that they still reflect the index being tracked. In many cases, this rebalancing involves buying more shares rather than selling them.
Moreover, ETF managers do not need to buy or sell securities every time an investor buys or sells a share of the ETF. This is because, unlike mutual funds, ETF shares are traded directly between investors. The seller trades ETF shares directly to the buyer, rather than going through the ETF manager.
The ETF manager ensures that the share price reflects the value of the underlying assets with the help of institutional forces known as “authorized participants.” Authorized participants trade only in large quantities—typically 25,000 shares or more—so there is no need to trade the underlying assets of the ETF every time an investor sells a single share.
Investors Control the Timing of ETF Taxes
Although the underlying stocks of an ETF trade less frequently, they still trade and incur capital gains taxes. However, there is a significant difference for ETFs, from the IRS’s perspective: capital gains taxes are only paid by investors when they sell the entire ETF. You will never pay taxes on ETF shares while you hold them.
On the other hand, mutual funds typically distribute capital gains taxes annually. Throughout the year, the mutual fund manager tracks capital gains taxes, along with things like dividend payments and capital gains distributions. At the end of the year, those numbers and little things are distributed to investors in proportion to the number of mutual fund shares they own.
Note:
Investors in mutual funds may not notice taxes because they can be distributed at the same time as dividends, but they are there. You pay taxes, even if you haven’t sold any shares of your mutual fund during the year.
Since ETF investors only pay capital gains taxes when they personally sell their shares, they can control when to impose taxes on themselves. They can use timing strategies to enforce these taxes when it is beneficial. While they wait for the perfect time to enforce taxes, their capital enjoys cumulative gains from tax deferral.
Taxes on Distributions for ETF Investors
The situation differs slightly when it comes to taxes on distributions for ETF investors. Instead, the situation remains the same with regard to other investments, as ETFs do not enjoy any special tax privileges for distributions.
Whether you own a single share, an index ETF, or a high-dividend ETF, the dividends will typically end up in your brokerage account as cash. Since you receive dividends in cash, you can expect to pay taxes on them. You will not receive any special tax privileges for receiving dividends from an ETF.
And while we’re on the topic of dividends, it’s worth noting that the IRS classifies dividends into two categories: qualified and ordinary. You can think of qualified dividends in the same way you think of long-term capital gains since both receive favorable tax treatment. Like long-term capital gains, dividends become “qualified” when the investor holds the security for a longer period (more than 60 days). In most cases, the dividends also need to be from a U.S. company to be qualified dividends, although some foreign companies issue qualified dividends.
An ETF investor can ensure they have held the fund for more than 60 days, but they cannot ensure that the ETF manager has held the underlying securities for more than 60 days. Therefore, ensuring that the dividends from ETFs are qualified is not as straightforward as ensuring that dividends from individual stocks are qualified.
Conclusion
An ETF offers significant tax advantages over a mutual fund. First, mutual funds typically incur capital gains taxes due to the frequency of trading activity. Second, capital gains tax on an ETF is deferred until the product is sold, whereas mutual fund investors will pay capital gains taxes while holding shares.
You should keep in mind that these advantages are not limited to ETFs; they also apply to ETNs (exchange-traded notes). ETNs are products similar to ETFs, but it’s important to understand all the potential implications of investing in any product before making a trade.
Source: https://www.thebalancemoney.com/etf-tax-advantages-over-mutual-funds-1215121
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