3 Reasons Why ETFs Are Tax Efficient

The beginning of the year allows investors to reset their portfolios, but to also strategically allocate their capital into more tax-efficient investment vehicles. One of those vehicles is the exchange-traded fund (ETF), which is lauded for its tax efficiency.

The ETF is often compared to the mutual fund when weighing the pros and cons of various investment vehicles. With tax season looming, here are three reasons why ETFs are tax efficient.

Legal Structure

The tax efficiency of ETFs is inherent in their legal structure as opposed to a mutual fund. Most ETFs are structured as open-end funds, which fall under the regulatory measures of the Investment Company Act of 1940.

As opposed to mutual funds, shares of an ETF are simply bought and sold through an exchange. Mutual fund shares are bought and sold directly through the mutual fund company, so the actions of other fund investors can affect an individual investor’s tax liability.

In essence, an individual tax investor doesn’t have control of the actions of his or her fellow mutual fund investors. In addition, a mutual fund manager must sell a portion of the fund’s holdings for shares redeemed, which could result in capital gains.

Those capital gains realized are then passed on to mutual fund investors. ETFs are not exposed to this type of taxable event.

The tax implications for ETFs can also vary according to their legal structure. A tax professional can help an investor navigate through the tax ramifications for each type of ETF structure.

Five types of ETF structures:

  1. Open-end funds: this structure is typically used for stock and bond asset classes.
  2. Unit investment trusts: typically used to track broad asset classes.
  3. Grantor trusts: typically used for physical commodities and currencies
  4. Exchange-traded notes: don’t hold underlying assets, but contain prepaid forward contracts
  5. Partnerships: unincorporated business entities that elect for taxation as a partnership

Fewer Taxable Events

The ETF is often praised for their tax efficiency since they use an in-kind exchange with an authorized participant. This means an ETF manager uses an exchange to sell the basket of stocks in a fund.