The tax efficiency benefit of ETFs (exchange-traded funds) quite often goes unnoticed when considering the other advantages like flexibility, low operating cost, and transparency. Looking towards the end of the year, we need to take stock of how an investor can reduce their tax liability by changing some of their portfolio instruments to ETFs. We will also look at other strategies in ETF trading that can lighten the tax burden. It would be wise to discuss your proposed action with your tax consultant first.
Taxes can have a negative impact on fund performance depending on the quality and timing of management. Even well managed mutual funds have lower tax efficiency than ETFs. Mutual fund managers, to fence in capital gains have been known to sell rather late in the year. The gains to current shareholders would be distributed pro-rata.
The indices tracked by ETFs generally sell and buy securities a lot less often than do mutual funds. There is therefore no need for most ETFs to distribute any year end capital gains to go into the 1099 form for your tax file. The largest suite of ETFs, iShares has never distributed capital gains to its investors. Lucky or astute investors, would you not say!
Another point is that shareholders of mutual funds redeem and purchase shares from the fund which could result in the distribution of gains to the other fund shareholders. An investor could find themselves falling afoul of capital gains commonly called "imbedded capital gains", whereby the sale of an investment made years ago affects a shareholder who was not in the fund then. The ETFs on the other hand sell and but ETFs on an exchange basis without affecting other shareholders. The ETF investor therefore has a better transparency and control on the liability.
These tax advantages that are clear to the eye can also be used as a toll in reducing your tax load.
Instead of keeping stocks that are held at a loss, an investor could turn to ETFs. An investor with, let us say, a loss on healthcare stocks in their portfolio, could sell them off and buy into an ETF sector like iShares DOW Jones U.S. Healthcare Sector ETF.
There are double tax benefits when switching to an EFT from a position of loss on a mutual fund that is actively managed. The first benefit is that of losing on capital without losing the value of the exposure. The second is a more efficient tax position and the added benefit of a limit chance of a distribution of capital gains.
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