ETFs are revolutionizing the way we invest and the reasons for
their popularity are not difficult to understand. They combine
the flexibility, ease and liquidity of stock trading with the
benefits of traditional index fund investing. Further, they are
generally less expensive, more transparent as well as more
tax-efficient than mutual funds.
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Mutual funds are infamous for causing tax headaches to
unsuspecting investors. ETFs on the other hand are tax smart due
to the way they are structured. However, there are some ETF
structures that are not very tax efficient and investors need to
be aware of the issues associated with them.
ETF Structure Creates Tax Efficiency
Since most ETFs track well-known market indexes, they usually
experience lower turnover compared with actively managed funds
and thus create lower tax liabilities.
But more importantly, ETFs are generally more tax efficient
compared with similar passively managed mutual funds, due to the
way they are
In other words, if an investor holds an ETF and a similar mutual
fund in a taxable account, the ETF will most likely result in
less tax liability for the investor.
The creation of an ETF begins with the sponsor, also known as the
manager filing a plan with the SEC, and on approval of the plan
executing an agreement with an authorized participant (AP), also
known as a market maker or specialist. AP in turn assembles the
appropriate basket of constituent stocks and sends them to a
specially designated custodian bank for placing them in a trust.
The custodian forwards the ETF shares (which represent legal
claims on tiny slivers of the basket of shares held in the trust)
on to the authorized participant. This is a so-called
trade of equivalent items and thus there are
no tax implications
On the other hand, when an investor purchases shares of a mutual
fund, the mutual fund has to create new shares by
the shares of the constituent stocks.
Similarly when an investor redeems his/her investment, the mutual
fund has to
the constituent shares.
The sale of stocks by the mutual fund (shareholder redemption or
portfolio turnover) may create capital gains for the
shareholders. So, the mutual fund investors may have to pay
capital gains taxes even if they have unrealized losses on their
According to WSJ, 26% of equity mutual funds paid out capital
gains in 2011, compared with just 2% of equity ETFs.
ETFs are however
tax free. Dividends from ETFs are taxed like dividends from
mutual funds or stocks. Capital gains at the time of sale also
receive similar treatment.
But overall ETFs-in particularly stock ETFs--are much more
tax-efficient than mutual funds and by creating lower tax
liabilities, ETFs result in higher long-term returns for
However not all ETFs are tax-efficient. Below we have highlighted
some specific situations that can cause some headaches for
Commodity ETFs that hold commodity futures (futures backed) are
structured as "limited partnerships" and are required to report
an investor's allocated share of a fund's income, gains, losses
and deductions on a Schedule K-1 instead of 1099. These are
somewhat difficult to handle.
Further gains or losses realized by ETFs are taxable events even
without any distributions being paid to shareholder. These funds
are subject to the so called "60/40" rule--60% of the gain is
subject to the long-term gains rate and 40% to the short-term
Precious Metals ETFs
Commodity ETFs that hold the precious metals (physically backed)
are treated same as holding the bullion itself. These ETFs are
structured as "grantor trust" for income tax purposes. Owners
(shareholders) of the trust are treated as if they owned a
corresponding share of the assets of the trust.
IRS treats precious metals as "collectible" for long-term capital
gains and as such gains are taxed at the rate of long-term
capital gains on collectibles if held for more than one year.
MLPs come with complicated tax issues and many investors avoid
investing in them only due to daunting tax requirements.
Thankfully for the investors, some of the tax complexities can be
avoided by owning them in ETP form. The payouts by the ETPs are
reported as ordinary income on Form 1099, and therefore the K-1
forms are not required.
Funds 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 the unrealized gains needs to be recorded.
As a result, MLP ETFs have significant tracking errors. The most
popular MLP ETF
has a gross expense ratio of 4.85% thanks mainly to deferred tax
Some ETFs avoid these adverse issues by limiting their exposure
to MLPs below 25%. ETNs also typically eliminate some of these
complex tax consequences, as they do actually not hold any
securities. But they come with credit risk of the issuer.
ETFs are generally "Extremely Tax Favorable" due to the way they
are structured, but some ETFs are structured differently and have
some tax issues that invetors should be aware of before they
decide to invest.
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