Category: Taxation

Much has been written about ETF tax efficiency. In this blog post, we summarize what these tax advantages look like to a individual investor who may be considering mutual funds as an alternative.

Let’s start with the basics of capital gains taxes. Short term capital gains are taxed as ordinary income, which for individuals in higher tax brackets, is far from ideal. Below are the tax brackets for married filing jointly in 2018.

So, let’s suppose you and your spouse made $175,000 in 2018. Then, for every additional $1 of short-term capital gains, you owe 24 cents of income tax. If you are fortunate enough to be earning more, tax rates are even higher. For this reason, higher earners often use municipal bond ETFs in their taxable portfolios.

What produces short-term capital gains?

There are several ways that individual investors produce short-term capital gains with ETFs and mutual funds.

• Buying an ETF or mutual fund and reselling it for a gain in less than a year.
• Non-qualified dividends, often produced by fixed income mutual funds and ETFs.
• Mutual funds that buy and sell assets in their fund to meet their stated objectives or to satisfy investor redemption*.

*This last point is where ETFs carry a significant advantage. The higher the turnover of a mutual fund’s assets, the more often short-term capital gains are passed on to the individual investor.

“If your fund distributes capital gains often, your tax bill may suffer.”

Source: “How Often Do Mutual Funds Pay Capital Gains?”, by
Claire Boyte-White, Investopedia.

But, ETFs have a creation/redemption process that shields these gains from the ETF investor. While some would say it’s a tax dodge, this process has represented a significant ETF tax efficiency for over 20 years. Below is a chart that shows how often these events occurred in comparable index ETFs and index mutual funds.

Conclusions

Tax efficiency is an important aspect that individual investors should consider. ETFs generally offer better tax efficiency than comparable mutual funds. While this efficiency is important for all investors, higher wage earners can reap the greatest tax benefits of using ETFs versus mutual funds.