ETFs & Tax Efficiency: What Investors Need To Know

Mutual funds are infamous for causing tax headaches to unsuspecting investors. Many investors do not know that ETFs are very tax efficient specially 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 - Research 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 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 miniscule for bond ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG - Research Report) and Vanguard Total Bond Market ETF (BND - Research 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.

Currency hedged ETFs like the iShares Currency Hedged MSCI EAFE ETF (HEFA) use derivatives like forward contracts to hedge out the foreign exchange exposure and if the US dollar appreciates significantly during the year, gains from these contracts are required to be distributed to investors.

Precious Metals ETFs like SPDR Gold Shares (NYSE:GLD) (GLD - Research Report) are treated same as holding the bullion itself. IRS treats precious metals as “collectible”, resulting in high tax rates for long-term capital gains.

MLP ETFs like Alerian MLP ETF (AMLP - Research Report) , that have more than 25% of their assets invested in MLPs, are treated as C corporations for tax purposes. Further, assets are required to be marked to market and a deferred tax liability for unrealized gains needs to be recorded, returning in large tracking errors.

To learn more, please watch the short video above.

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