One of the primary purposes of financial planning is to maximize wealth through income by minimizing tax payments. By utilizing tax-efficient investment alternatives, financial planners can help bring in a larger proportion of the returns that you deserve from your investments. In a world where there are many different investment opportunities, ETFs offer investors a mix between individual securities and mutual funds by offering ownership of a diversified fund as a single entity.
Tax laws give ETFs certain tax implications that are more appealing for investors who are looking for long-term gains from their investments. According to current U.S. tax laws, investments are only taxed when there are realized gains. These gains can come from interest payments, dividends, or the sale of investments. However, there is no tax implication for a stock appreciating in value but remaining held by an investor. In an ETF, all of the investments held by the fund will remain in their current condition. Any gains made by the securities in the fund will only be taxable when the investor sells their shares of the ETF.
The tax advantages of ETFs can be further enhanced by:
- Gifting ETF shares to a family member in the 0% capital gains tax bracket
- Gifting the shares to charity
- Leaving the shares in an estate since they will step up in basis upon the owner
However, investors are still able to be taxed on any income received through dividends or interest payments.
ETFs try to offset this by taxing dividends based on duration of ownership. If an investor owns an ETF 60 or more days before a dividend is declared, it is considered a “qualified dividend,” meaning it is taxed from 0% to 20% depending on your income tax rate. If you do not meet the 60 day minimum, the dividends will be treated the same as they would in a mutual fund and be taxed at your ordinary income tax rate.
ETFs v. Mutual Funds
The benefits of these tax laws are further emphasized when directly comparing ETFs to mutual funds. As mentioned earlier, the biggest tax implications for investors come in the form of capital gains. This is one of the first places where ETFs separate from mutual funds. In a mutual fund, fund managers can buy and sell securities at any point, creating a taxable event every single time there is a trade. The structure of ETFs does not create any taxable events, barring unforeseen circumstances, until the shares are sold. Therefore, the longer the investment is held, the further amplified this benefit becomes. According to data provided by Morningstar, only 10% of ETFs have capital gains distributions over 5 years compared to 55% of mutual funds.
Another advantage that this factor brings is the lessening of behavioral biases by a fund manager. Unlike a mutual fund, ETFs cannot trade singular securities. In a mutual fund, managers are able to sell single securities for a profit, even if the overall fund is in a loss. This is yet another example of a taxable event that lessens the income you receive from investments.