Understanding the Tax Efficiency of ETFs | ETF Trends

Many investors look to ETFs due to the inherent tax efficiency of the structure.

Generally, holding an ETF in a taxable account will generate fewer capital gains tax liabilities than holding a similarly structured mutual fund in the same account, according to Fidelity Investments.

Mutual funds and ETFs are subject to capital gains tax and taxation of dividend income. While tax treatment of dividend/interest income is unchanged in the ETF structure (pass through), there has historically been a wide disparity between annual gains paid from mutual funds and the lower rates/propensity paid by ETFs. However, upon sale, an investor will pay a capital gain (short or long-term depending on their holding period) on both a mutual fund or an ETF.

ETFs Can Accommodate Investment Flows

Compared to mutual funds, ETFs typically experience fewer realized capital gains in a given year.

A mutual fund manager constantly rebalances the fund by selling securities to accommodate shareholder agreements or reallocate assets. The sale of securities within the mutual fund portfolio creates capital gains for shareholders. This also applies to shareholders who may have an unrealized loss on the overall mutual fund investment.

On the other hand, ETFs can accommodate investment outflows by creating or redeeming creation units. Creation units are baskets of the fund’s underlying securities in their appropriate weightings. According to Fidelity, this means the investor is usually not exposed to capital gains on any individual security in the underlying structure.

ETF managers are generally able to minimize the chances of realizing gains inside the fund through use of this non-taxable in-kind transfer of securities. Therefore, it is unusual for an active or index ETF to pay out a capital gains when holding a basket of long-only positions.

Capital Gains & Taxation of Dividends

Investors who realize a capital gain after selling an ETF are subject to the capital gains tax. This rate is based upon the investor’s holding period and tax rate.

Furthermore, like mutual funds, ETF dividends are taxed based on how long the investor has owned the ETF. 60 days is a key milestone. If the investor held the fund more than 60 days before the dividend was issued, it is considered a qualified dividend. It’s then taxed anywhere from 0% to 20%. This figure depends on the investor’s income tax rate.

However, if the investment was held less than 60 days before the dividend was issued, then it is taxed at the ordinary income tax rate.

For more news, information, and analysis, visit the ETF Investing Channel.

Fidelity Investments® is an independent company, unaffiliated with VettaFi LLC (“VettaFi”). These articles do not form any kind of legal partnership, agency affiliation, or similar relationship between VettaFi and Fidelity Investments. Such a relationship is not created or implied by the articles herein. VettaFi LLC is the author and owner of these articles.

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