June 30, 2022

Are ETFs more tax-efficient than mutual funds?

 

It’s a question that has been debated for years, and there is no clear answer. Both ETFs and mutual funds can be subject to capital gains taxes, but the way these taxes are paid may vary.

With a mutual fund, the fund company pays the capital gains taxes on behalf of the shareholders. It means that the shareholders do not have to pay any taxes on their share of the profits, as long as they hold their shares in the fund for more than one year. However, this also means that the mutual fund shareholder cannot benefit from any losses incurred by the fund.

ETFs are structured differently

The company that creates an ETF does not pay any capital gains taxes. As a result, individual investors would need to pay taxes on any gains they make from their share of ETF profits. However, the taxation is based on each investor’s capital gains tax rates and not at the fund level.

Tax-friendly ETFs

Even though many people believe that mutual funds are more tax-friendly than ETFs for capital gains taxes, there are some cases when ETFs can be more beneficial in this area.

One example is when an investor has made short-term trades in securities within their account. It can happen when an investor sells shares before owning them for one year. Single security bought and sold within twelve months means that the investor must pay 25% in short-term capital gains.

For example:

Let’s say that an investor buys 100 shares of XYZ company in February. He sells the shares one month later for a total of $1,350. His capital gain is $1,250 ($1,350 minus his original investment of $100). However, half this amount would be taxed at the short-term capital gains rate (35% in 2013). It means that he owes 35% on $625 (half of $1250) in addition to his regular income taxes

If the same investor had bought an ETF representing XYZ company instead of individual common stock when he originally invested, there would be no difference when it came time to sell his position. He would still owe short-term capital gains taxes on the profits but at the individual investor’s tax rate instead of the fund level.

Benefits of ETFs

In some cases, ETFs may also be more beneficial for estate planning. Mutual funds are required to pass along their capital gains and losses to their shareholders upon death. However, this is not the case with ETFs.

When you own an ETF, the person who inherits your shares will not be responsible for any capital gains taxes that have been paid on the investment. It can be a significant advantage in estate planning, as it can help reduce or avoid any potential tax liability for the estate.

That being said, there are some scenarios where an ETF can be more tax-efficient than its equity benchmark index mutual fund alternative.

The primary advantage for most ETFs is the ability to trade them throughout the day rather than only once per day, during an exchange’s closing hours. It’s appealing for many reasons, but the most important reason is that it allows traders to access international exchanges without incurring additional trading fees. The only difference is that you are trading security rather than owning stock in an underlying company with ETFs. An obvious drawback of this is with ETFs, and you are not making any long-term capital gains investments because you are simply swapping back and forth between securities.

Also, another advantage is with some actively managed mutual funds that charge investors a percentage of assets under management (AUM) each year. In contrast, ETFs tend to have fewer fees associated with them, giving them more significant tax benefits. However, one clear disadvantage compared to mutual funds is that ETFs typically have higher expense ratios because of the required technology and service support to allow trading during market hours.

Bottom line

The tax benefits associated with ETFs can vary depending on your situation. You must speak with a financial advisor to ensure that you make the best possible investment decision.