Using ETFs to Avoid and Minimize Capital Gains Liabilities | ETF Trends

Experienced advisors and investors know that exchange traded funds, in most cases, are significantly more tax-efficient than actively managed mutual funds.

Much of ETFs’ tax advantage over mutual funds stems from the creation/redemption mechanism used by ETFs. When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event. This isn’t always the case with ETFs.

While that may be “ETF nerd” stuff to many investors, there are some approachable ways for everyday investors to further mitigate capital gains exposure while using ETFs.

“Another way to potentially reduce the impact is to invest in tax-efficient exchange-traded funds (ETFs),” according to Invesco research. “The unique structure of index-based ETFs means that they’re not necessarily required to sell holdings to cover investor outflows (instead, they can use an ‘in kind’ mechanism to create and redeem fund shares). In general, index-based ETFs can potentially distribute gains in rare circumstances, such as dramatically rebalancing a portfolio because of significant changes to its underlying index.”

More good news for investors: Some of the most popular ETFs have lengthy track records of not subjecting investors to capital gains obligations. That group includes the venerable Invesco QQQ Trust (QQQ) and the Invesco S&P 500 Equal Weight ETF (RSP), the largest equal-weight ETF.

“Invesco has 191 ETFs that have not paid any capital gains distributions in the past five years. And many, such as Invesco QQQ, Invesco S&P 500 Equal Weight ETF, and Invesco Taxable Municipal Bond ETF, have never paid capital gains distributions in their lifetime,” says the issuer.

Conversely, many mutual funds deliver capital gains, and some of those tabs can be burdensome to investors.

“In 2020, 57% of US equity mutual funds paid capital gains distributions to their shareholders,” notes Invesco. “Over the past 10 years, the average annual distribution from US equity mutual funds ranged from 4% to 8% of the fund’s net asset value. Paying taxes on those distributions can erode portfolio returns over time.”

Bottom line: ETFs are more tax-efficient than mutual funds, and investors can amplify those benefits by deploying ETFs in tax-advantaged retirement accounts.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.