Exchange traded funds are touted for their tax efficiency. However, some funds may come with unrealized capital gains even if investors think they are safe and haven’t made any ETF sales this year.
According to a recent BlackRock study, around 55% of investors don’t realize that ETFs could pay capital gains even though the security was not sold at the end of the year.
“While ETFs can be highly tax-efficient investment products, many investors are surprised to find out that it’s possible to owe taxes on capital gins distributions made by ETFs even if they didn’t sell the security at a gain that year,” Patrick Dunne, iShares Head of Global Markets & Investments, said in a research note. “When it comes to tax efficiency, investors need to be asking the right questions or they may get a surprise in their tax bill at the end of the year.”
Typically, when it comes to taxes, ETFs are more efficient than mutual funds because of the way the fund products are structured. Unlike mutual funds, ETFs usually don’t sell underlying holdings for cash, which would trigger a taxable event.
Instead, the ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa. [In-Kind Creations and Redemptions]