Exchange-traded funds (ETFs) have been available since 1993. They have grown in popularity every year since their inception. A simple way to view ETFs is to consider them as mutual funds that trade like stocks. Remember that mutual fund shares are always purchased and sold directly. The tax advantages are one of the most significant benefits of ETFs.
1The Impact of Capital Gains Taxes
Mutual fund investors incur capital gains taxes. Because an active fund manager trades the assets of a mutual fund, capital gains taxes must be paid whenever equities are sold for a profit. Over time, these taxes can significantly erode your gains.
2Activities That Trigger A Tax Event
Shareholder redemption can trigger a tax event. If the monetary amount of shareholders leaving the fund is greater than the number of shareholders joining the fund, a sale of the funds' equities will most likely occur. Portfolio turnover can also trigger capital gains taxes when equity is sold for a profit.
Corporate actions are the third tax-triggering event. Stock splits, acquisitions, and similar activities can also trigger a tax event. These depend on the details of the corporate action.
3Mutual Funds Versus ETF
The mutual fund creates new shares by using the investor's money to purchase the proper amount of shares of stock or an appropriate amount of bonds. When the investor sells their mutual fund shares, the fund must sell equities to raise the money. This is done to return the same value of those shares to the investor.
An investor in an ETF simply buys the shares from another investor on the exchange that lists the ETF. This means that no new shares are created. When the investor wants to cash out, he simply sells his shares to another investor via the same process.
4The Tax Advantage Of ETF
The capital gains tax only becomes due when you sell your stake in the ETF. Taxes are never due while you are still holding the ETF. ETFs do not turn over their assets at a high rate, but some turnover does occur.
The taxes on these gains are not realized until the entire stake in the ETF has been sold to another investor. Therefore, all your realized gains continue to grow. This is significantly different from having to pay those taxes each year, which is limiting.
5Benefits For ETF Investors
Mutual funds must sell equities whenever someone wishes to sell their shares. Since an ETF is traded like a stock, investor turnover has little effect on the asset turnovers in an ETF. This in-kind redemption process permits the ETF manager to sell the lower cost-basis stocks through transfers and by minimizing or avoiding taxes.
And these are not considered sales, so no tax is triggered. There is greater tax efficiency with an ETF because the activity of the shareholders and the subsequent equity transactions have a minimal effect on the portfolio. The after-tax returns are usually quite better with an ETF than a mutual fund that tracks a similar index.
ETFs offer many of the advantages of mutual funds. But they usually have less tax exposure. Many investors underestimate the impact of taxes on their long-term success.
Deferring taxes is highly advantageous. This is because you can continue to earn money on the capital of which you would have turned over to the government in the form of taxes. It could be very beneficial for you to take a serious look at exchange-traded funds.