One of the things investors like best about exchange traded funds is their tax efficiency relative to regular mutual funds. With April 15 rapidly approaching, now is a great time to brush up on the tax advantages of ETFs.
Because of the way the ETF investment vehicle is constructed, investors can expect a different tax treatment compared to mutual funds come tax time.
Here are three things you should know about ETFs’ tax efficiency:
- Low Turnover. ETFs buy and hold components of a market benchmark, and the ETFs don’t often shift around their portfolio holdings since their underlying components don’t often experience significant changes. Consequently, the low turnover rates help limit the capital gains that the ETFs may have issued to investors. [8 Things You May Not Know About ETFs and Taxes]
- ETF Arbitrage. Mutual funds often redeem or create shares by selling stocks and taking on cash positions, which generate taxable events. Unlike mutual funds, ETF shares are created and redeemed in “in-kind” transactions with market makers, or authorized participants. Authorized participants exchange a bundle of securities to create an ETF share or redeem an ETF share for a bundle of securities. Since the ETFs swap securities for ETF shares in in-kind transactions, no cash is exchanged and the funds do not take on gains. [ETFs and Taxes]
- Underlying Holdings. Investors, though, need to be aware of the type of securities an ETF holds. For instance, investors will be required to fill out a Schedule K-1 form instead of the normal 1099 form for non-stock ETFs, such as commodities futures-based funds. Additionally, physically-backed ETFs that hold precious metals are also taxed as collectibles at a 28% rate. [Commodity ETFs and Taxes: What to Know]
ETF investors should always consult their tax experts for specific tax related advice.
For more information on taxes in ETFs, visit our taxes category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.