David I. Cohen, Partner, Compoundr LLC

EXECUTIVE SUMMARY

ETFs have gained traction over the past 20+ years and are generally accepted as being more tax-efficient than their mutual fund counterparts. However, the tax efficiency of an ETF primarily refers to its ability to allow an investor to defer paying capital gains taxes until she sells her fund at the end of her investment horizon. Despite being able to defer capital gains, ETFs usually still make dividend distributions, which are typically taxable events for the ETF investor in taxable accounts throughout her investment horizon. If an investor is income-agnostic, and chooses to reinvest dividend distributions, she must still pay income taxes on her dividend resulting in a tax drag to long-term total returns.

Financial advisors currently deploy numerous creative tax-strategies at the portfolio level; still, no one can dispute that the development of a tax-advantaged version of income-dominant assets would be a welcome addition to the U.S. ETF landscape. Is it possible for ETFs to circumvent this remaining tax burden to become fully tax-efficient? In today’s article we explore a potential solution that could harness the custom creation & redemption mechanism already present in ETFs to compound the tax-efficiency of the investor’s experience.

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