ETFs: Are they the most tax-efficient investment?

By ETFsFOXBusiness

Investors continue to pour money into ETFs

ETFTrends.com publisher Tom Lydon and B. Riley FBR chief market strategist Art Hogan discuss how to sell ETFs in this volatile market.

Market performance is impossible to predict, but when it comes to maximizing profits, there is something well within investors’ control: taxes. For that reason it makes sense for investors to minimize the taxes they pay on their investments.

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The Schwab Center for Financial Research examined the long-term impact of expenses, including taxes, on investment returns and found that just behind asset allocation, minimizing taxes and costs are imperative in maximizing returns.

Mutual funds are a popular investment vehicle, and it is important to note that when it comes to comparing Exchange Traded Funds (ETFs) and mutual funds, there are tax implications.

One of the primary advantages touted for ETFs is their tax efficiency. ETFs are taxed more favorably versus their mutual fund cousins due to their unique structure.

When an investor sells an asset and turns a profit, Uncle Sam wants his piece of the pie. These capital gains taxes are not only triggered when an owner sells an investment, but also when a mutual fund manager sell securities as part of a tactical move. By law, if funds accrue capital gains, they must pay them out to shareholders at the end of each year. This can lead to an unpleasant surprise for the investment's holder at tax season.

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For fund investors, the structure of an ETF means that there is less juggling that could lead to a taxable event. According to data from ETF.com, the average emerging markets equity mutual funds paid out 6.46% of their net asset value (NAV) in capital gains to shareholders, every year. ETFs do much better with the average emerging market ETF paying out just 0.01% of its NAV as capital gains over the same stretch.

When a mutual fund investor wants to cash out, the mutual fund has to sell securities to generate the cash necessary to pay out that investor. But, when an ETF investor wants out they can simply sell their ETF to another investor, just like a stock. This means no capital gains taxes for the ETF. In fact, with ETFs, capital gain taxes are only realized when the entire investment is sold versus a mutual fund which is assessed a capital taxes every time assets in the fund are sold.

Taxes on ETF dividends

Dividends are a payout, therefore, they are also taxed. When it comes to ETF dividends, there are two types and they are taxed differently. The IRS classifies ETF dividends as either qualified or unqualified. A qualified dividend is when an investor has equity in the fund paying the dividend for more than 60 days in the 121-day period that begins 60 days before the ex-dividend date. The tax rate on qualified dividends is anywhere from 5% to 15%, depending on the holder's income tax rate.

In unqualified dividends, payouts don't meet the above qualifications and these dividends are taxed at normal income tax rates.