The markets of late have found all kinds of reasons to love exchange traded funds, and at tax time, one of the reasons to love ETFs becomes crystal clear: tax efficiency.
If a mutual fund enjoys a capital gain when selling off an appreciated stock, holders are on the hook with the IRS for paying the capital gains tax regardless of whether they sell or whether the fund's share price has gone up or down since the holder bought it. But while taxes can wipe out as much as two full percentage points for mutual fund investors in the highest tax brackets, such losses are very unlikely to happen in the world of ETFs, says registered investment advisor Russell Wild, president of Allentown, Pa.-based Global Portfolios.
"The bottom line is that when somebody owns an ETF, typically there are little to no pass-through capital gains on portfolio turnover" compared with a mutual fund, explains Adam Patti, chief executive of the Rye Brook, N.Y.-based ETF firm IndexIQ. "There are still long-term or short-term capital gains on an ETF when you buy or sell, that doesn't go away, but if you have a mutual fund and you're down 10% for the year, you could still have a pretty big tax bill on that fund if there was a lot of turnover in the fund and some of those positions made money. The ETF structure eliminates some if not all of those pass-through capital gains."
Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory (left), notes that stock and bond ETFs are the easiest ETFs to figure from a tax perspective, and the simplest way to deal with the tax consequences is to invest in ETFs that don't distribute dividends. Gold or other precious-metals ETFs, on the other hand, result in a higher tax rate on long-term gains for collectibles, Iachini says.
And then there are the commodity ETFs that use futures, which are affected by contango and backwardation.
"ETFs that use futures are structured as limited partnerships, and the partnerships get more complicated," Iachini said in a phone interview. "There's this weird rule from IRS Publication 550 about how gains you get are treated as 60% long term, 40% short term under these commodities partnerships that have K-1s. That's good for you if your gains are short term, but bad for you if they're long term, because you'll still have to count some of them as if they're short term. You need to know what you're getting into, otherwise you might be surprised when you get a K-1."
Here are the essentials to keep in mind for ETFs at tax time:
The Basics
Advisors should keep in mind that ETFs that generate income—whether interest, dividends or capital gains—are best kept in a tax-advantaged retirement account, says Wild, a registered investment advisor certified by the National Association of Personal Financial Advisors (NAPFA) and author of Exchange-Traded Funds for Dummies.
"You'll eventually need to pay income tax on any money you withdraw from those retirement accounts, but it is generally better to pay later than sooner," writes Wild, who primarily uses ETFs to build his clients' portfolios, in a recent blog post.
In the case of a Roth IRA, "which is often the best case of all," you will never have to pay taxes on the earnings, the principal, what is in the account, or what you withdraw, Wild adds. "Try to put your ETFs or mutual funds that have the greatest potential for growth—REIT ETFs are great candidates—into your Roth IRA."
The Tax-Efficient Way to Go: Stock and Bond ETFs
