One of the biggest selling points of exchange traded funds is that these products are remarkably tax-efficient relative to other fund structures.

While saving on taxes is important, many investors — particularly those new to ETFs — focus on fees, asset class, underlying themes and indexes, and upside potential. All of those are vital traits, but investors are apt to focus on those and forget about tax benefits, meaning that advisors have room to initiate client conversations about the tax perks afforded by ETFs.

“ETFs owe their reputation for tax efficiency primarily to equity ETFs, which can hold fewer than 25 to more than 7,000 different stocks. Although similar to mutual funds in this regard, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains,” writes Emily Doak of Charles Schwab.

Put simply, when a mutual fund manager exits a profitable position, the fund issuer doesn’t absorb the capital gains taxes. Rather, the tax consequences are passed onto the fund’s investors. That doesn’t happen with passive ETFs, generally speaking, and much of that benefit is derived from how shares of ETFs are created and redeemed.

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.

“Profits on ETFs sold at a gain are taxed like the underlying stocks or bonds as well,” adds Doak. “If your overall modified adjusted gross income is above a certain threshold ($200,000 for single filers, $125,000 for married filing separately, $200,000 for head of household, and $250,000 for married filing jointly or a qualifying widow(er) with a dependent child), you’ll owe an additional 3.8% Net Investment Income Tax (NIIT). In our discussion, the maximum rates include the NIIT.”

Investors that turn a profit on equity and fixed income ETFs held for less than a year incur a maximum tax rate of 40.8%. For investors embracing gold and silver ETFs and the like, there are different tax implications.

“The IRS treats investment in a precious metals ETF the same as an investment in the metal itself, which—for tax purposes—would be considered an investment in collectibles. The maximum long-term capital gains rate on collectibles stands at 31.8%, which is higher than the 23.8% top capital gains rate you’d pay for an equity ETF. On the other hand, short-term gains on collectibles are taxed as ordinary income,” according to Doak.

Bottom line: Straightforward ETFs have straightforward tax obligations. Funds providing exposure to some alternative investments, exchange traded notes (ETNs), and other structures carry different liabilities, confirming that there’s fertile territory here for advisor/client engagement.

“If you invest in stocks and bonds via ETFs, you probably won’t be in for many surprises. Investing in commodities and currencies is certainly more complicated. As more exotic ETFs come to market, we’ll possibly see new tax treatments, and no tax law is ever set in stone. Always consult with your tax professional for any questions about the taxation of ETFs,” concludes Doak.

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