Exchange traded funds are touted for their tax efficiency. Nevertheless, not all fund products are created equal, and investors should be aware of the varying tax consequences for different investments.
For instance, Micahel Rawson, ETF analyst with Morningstar, points out that certain asset classes are better of in tax-deferred accounts, such as ETFs that focus on interest income, which is taxed at ordinary income tax rates. [iShares: Calculating the Cost of New Tax Increases]
Specifically, a high-income investor would have been better served with a municipal bond ETF for a taxable account because of the tax-free aspect in muni investments, whereas ETFs that track the aggregate bond market, which includes bonds without any tax perks, would do better in a tax-deferred account. [A Quick Primer on ETF Tax Efficiency]
Additionally, non-qualified dividends, like REITs ETFs, would also be better in tax-sheltered accounts since the dividends are taxed at investors’ ordinary income rates.
“Naturally, you would put dividend-paying funds in a tax-deferred account first, but those with large taxable accounts should not necessarily avoid dividend-paying stocks,” Rawson said in the article. “It is important to remember that it is the total aftertax return that is most important, not necessarily minimizing taxes.”
When compared to mutual funds, investors have found that ETFs offer greater tax efficiency because of their innate creation/redemption process – ETFs don’t sell holdings but use “in-kind” transfers, or shares-for-shares, which reduce the possibility of future capital gains distributions.
Rawson, though, points out that the tax benefits form the in-kind creation/redemption process diminishes with international-focused ETFs.
“In summary, tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs,” Rawson said.
For more information on ETFs and taxes, visit our taxes category.
Max Chen contributed to this article.