Tax season is well and truly upon us, and while ETF taxes may be front of mind at the end of the calendar year, April’s tax season should be a powerful reminder of the power of ETF tax efficiency. Per new research from American Century, that power may even have been relatively underrated, and with an ETF like American Century Diversified Municipal Bond ETF (TAXF), there are ways to take efficiency even further.
Just because the end of 2023 is some distance away shouldn’t stop investors for looking at how to avoid capital gains. Tax loss harvesting, which involves offsetting gains with capital losses, benefits notably from the flexibility inherent to the ETF wrapper, with the ETF structure also minimizing capital gains until shares are actually sold. Deferring gains also allows assets to remain invested and compounded at higher rates, potentially.
While mutual fund flows are transacted in cash, requiring mutual fund managers to often sell portfolio securities and create gains for all fund shareholders, ETF managers accommodate inflows and outflows thanks to the in-kind share creation and redemption process. ETF share transactions also occur without transactions among underlying securities, adding additional liquidity.
Taking a look at ETF vs mutual fund capital gains distributions, the gap between mutual funds and ETFs is stark — indexed and active equity ETFs had drastically fewer from the inception of each example ETF to December 31, 2022.
Recognizing the power of ETFs to limit distributions and move nimbly through tax limiting strategies, investors can also take ETF tax efficiency one step further in a strategy like TAXF. TAXF is actively managed and invests in both investment-grade and high yield municipal bonds that boost income while reducing tax exposure. Considered a relatively safe investment, munis do include some riskier categories, with the riskier variety comprising up to 35% of TAXF’s portfolio.
See more: “Bull vs. Bear: A Town Hall On Muni ETFs”
Charging 29 basis points, TAXF is targeting its five-year milestone this year, and has outperformed the Bloomberg Municipal Bond index on a YTD basis. For those advisors looking to boost their use of ETF tax efficiency for their clients, TAXF could be one potent way to do so in the weeks and months to come.
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