When it comes to investing, whether it be through stocks, bonds or exchange traded funds (ETFs), the tax implications are always on an investor’s mind. Do you know how ETFs can affect your capital gains?
ETFs are desirable products. They’re low-cost, diversified, they trade all day on an exchange like a stock.
One thing that makes ETFs more desirable than their mutual fund counterparts is their inherent tax efficiency. In general, ETFs are less likely to shoot off capital gains because they passively buy and hold baskets of stocks in an index, usually resulting in lower turnover and lower realization of capital gains.
This is a function of the in-kind redemption process. Unlike mutual funds, ETFs don’t have to sell securities to redeem shares. Redemptions are made by the authorized participant and are met by transferring stocks. Bear in mind, too, that most ETF capital gains distributions are very, very small and the majority of ETFs manage to avoid issuing them entirely.
In fact, Morningstar examined distributions by ETFs that track 27 indexes and found that ETFs in 25 of the categories had no capital gains distributions in the previous five years. The other two categories had very small distributions, reports CBS Moneywatch.