How Exchange-Traded Funds Keep the Taxman at Bay
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How Exchange-Traded Funds Keep the Taxman at Bay
Exchange-traded funds keep the taxman at bay in several ways.
Things To Know
- Most ETFs are index funds, which keep trading to a minimum.
- In-kind redemptions are non-taxable.
Most are index funds
First of all, exchange-traded funds are tax-efficient because the majority of them are index funds. Most index funds keep trading to a minimum, which means fewer taxable gains are realized, and the few gains that are realized often qualify for the lower long-term capital gains tax rate.
They are protected from the cash flows
ETFs are shielded from unpredictable and frequent shareholder cash flows that can also trigger tax consequences. With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to all shareholders. In contrast, trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions.
In-kind redemptions
Furthermore, redemptions made by large investors are paid "in kind," which is a non-cash, non-taxable transaction in which shares of the ETF are exchanged for the underlying holdings, again protecting shareholders from taxable events. All of this should make ETFs more tax-efficient than most mutual funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.