Many investors, old and new, have been attracted to exchange traded funds for the investment vehicle’s tax efficiency.
Compared to traditional mutual funds, ETFs are more tax-efficient investment vehicles that incur fewer capital gains disbursements, David Rae, a certified financial planner, writes for Forbes.
“As a financial planner who loves tax planning, being more tax efficient with your investments is essential to improving net after-tax investment returns without necessarily taking on more investment risk,” Rae explains.
Specifically, when an investor sells a mutual fund, the fund manager is forced to sell securities in the portfolio to raise cash to fund the sudden redemption, which triggers a taxable event. In comparison, when an investor sells an ETF, they sell that investment bucket, or the ETF shares, to another investor on the open market, so there is no taxable trade of the underlying holdings.
Nevertheless, ETF investors are still faced with capital gains (or capital losses) on the sale of the whole ETF.
The tax-efficient nature has helped resonate with many investors, especially those who have grown dissatisfied with their mutual fund holdings. In 2021, the ETF industry attracted about $500 billion in new inflows. On the other hand, the mutual fund industry saw about $362 billion in outflows. While ETFs continue to chip away at mutual funds, it is not the death of the traditional fund industry.
“While I do see the shift toward ETFs continuing, I don’t think mutual funds are going away any time soon. Many Americans own mutual funds within their workplace retirement plans. For tax-deferred accounts like an IRA, 401(k), or even a Cash Balance Plan, tax efficiency is not an issue for the underlying investments,” Rae adds.
Additionally, Rae warns that mutual funds come with so-called phantom income, where investors can lose money in a mutual fund and still see substantial capital gains taxes. As other mutual fund investors sell shares, other owners are exposed to the capital gains distributions throughout the year.
“In this scenario, you could almost think of this as playing hot potato- someone gets left holding the proverbial bag of hot potatoes- capital gains,” Rae says.
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