The tax debate has gone national and now it extends from Congress right into your own portfolio.
Everyone has an opinion on tax rates, whether they are based on income or capital gains. While the national income tax debate rages on, the good news is that some investments offer better tax efficiency than others. Take the case of ETFs.
ETFs are designed to be more efficient tax structures than mutual funds. As a result, they can pay long-term capital gains, but at a lower rate than mutual funds or none at all. This stems from the ETF structure itself. ETFs track an index, so there are fewer opportunities to create portfolio changes. Plus, ETF shares are bought and sold on exchanges like stocks. When an ETF is sold, there is no sale of securities, so there are no capital gains to pass along to existing ETF investors.
But beware: Not all ETFs are treated equally by the tax code. Gold, bond and real estate ETFs have different rates than the majority of other ETFs, and may be best suited to be held in tax deferred accounts.
ETFs have small distributions because they are designed to track an index. As a result, they are passively managed and have lower portfolio turnover. When shares are redeemed in an ETF, it only exchanges shares for individual securities. Alternately, a mutual fund has to actually sell securities when a shareholder exits the fund and this sale generates taxable distributions for shareholders.
As an example of their lower capital gains structure, iShares has prepared a table comparing its ETFs against actively-managed mutual funds in a variety of categories over a 10-year period (2000 to 2009). In one chart, the iShares Russell 1000 Growth Index Fund (IWF) had a capital gains rate of 0% compared to 2.0% for the average, actively-managed large U.S. open-end growth fund over the 10-year period. In the value fund category, the iShares Russell 1000 Value Index Fund (IWD) had a capital gains rate of 0% compared to 2.9% for the average, actively-managed U.S. open-end large value fund over the decade.
But ETFs can incur capital gains when they make adjustments to their holdings as a result of changes in an index’s components. To make these changes, the ETF must buy or sell individual holdings to mirror the underlying index.
One way to track an ETF’s performance to its index, and as a means of gauging its tax efficiency, is by comparing the two price movements on Morningstar. This can be done by selecting the specific ETF and then accessing the Performance tab. In general, the smaller the tracking error, the less risk of incurring a capital gain, as long as there are no changes in the components of the underlying index. Dividends and capital gains (long- and short-term) data can also be found on an ETF’s opening page at Morningstar.
Special ETF Situations to Consider
ETFs are growing in popularity and volume and now encompass a broad variety of investments, ranging from precious metals and real estate to stock indexes. As a result, the tax treatment on some ETFs differs from others.
Specifically, investors should watch out for the special tax treatment which applies to the very popular gold ETFs, as well as gold bullion and coins. Gold ETFs are taxed at the collectibles tax rate of 28%, instead of the long-term capital gains rate of 15%. Short term gains are taxed as ordinary income. Because of this rate differential, investors who own gold ETFs should hold them in non-taxable IRAs and 401(k) retirement accounts.
Bond ETFs also are taxed at the rate you pay for regular income. Real estate investment trust (REIT) ETFs should also be held in a tax-deferred account over the long-term since they can generate high taxable income.
What About ETFs in Non-Taxable Accounts?
The good news is that year-end distributions are not an immediate problem in tax-favored retirement accounts, such as 401(k), 403b, 457, traditional IRA, and Roth IRA accounts. Your tax liability, if any, is deferred until you begin to take distributions. Then, there are also different options available for moving tax-efficient funds into tax-deferred accounts and moving taxable funds into tax-deferred accounts.
In general, a more tax efficient fund can perform on the same level as a less tax-efficient fund after you consider its tax impact. If you find a fund which is not very tax-efficient, you can put it into a tax-deferred account. Then, you can move the more tax efficient fund into a taxable account. There is also the established practice of harvesting tax losses over the course of the year. When you do this, you accumulate a reserve of tax losses that can be used to offset capital gains distributions.
Like mutual funds, ETFs have an ex-date, record date and a pay date. Distributions are commonly made quarterly, but some firms, such as iShares, have monthly, quarterly and semi-annual distributions depending on the type of fund. For example, Barclay’s non-U.S.-Global MSCI, NASDAQ, FTSE, S&P Global and asset allocation funds are on a semi-annual calendar. All the distribution schedules are commonly found on the ETF distributor’s Web site.
