ETFs: A Not-So-Secret Tax Strategy
When it comes to investing, every dollar spent on capital gains taxes is a dollar diverted from potentially earning returns. That’s why having tax-savvy investing strategies is always a good idea. Exchange-traded funds (ETFs), which have built-in tax advantages, are one way to keep more money invested and working for you rather than Uncle Sam.
Two Possible Drivers for Higher Capital Gains Taxes
Despite volatility, markets have continued a path of positive returns that began after the 2008 financial crisis, leading many mutual fund portfolios’ holdings to have high levels of unrealized capital gains. New entrants may be liable for capital gains distributions resulting from portfolio activity, even if they haven’t realized the returns in their portfolios. That means investors can have negative year-over-year returns in a mutual fund investment and still incur a capital gains tax.
Capital gains taxes are a frequent policy topic, regardless of the administration in office. Currently, the Biden administration is exploring capital gains tax rate changes. Meanwhile, although the Tax Cuts and Jobs Act of 2017 lowered capital gains income thresholds across the board, it also linked each bracket to inflation, which in the current environment may trigger threshold increases.
Why ETFs Are More Tax Efficient Than Traditional Mutual Funds
Both ETFs and mutual funds are subject to taxes on the difference between market value and cost basis when they are sold—a realized gain. They also are subject to taxes on capital gains and income incurred while shares are held.
Generally, ETFs generate less tax liability during the investment period than similarly structured mutual funds. Thus, the investor keeps a larger pool of assets invested compared to mutual funds to potentially earn returns and benefit from the power of compounding.
ETFs access two features that reduce their exposure to events that trigger capital gains, enabling deferral of tax liability.
1. ETF Shares Are Bought and Sold More Tax Efficiently Than Mutual Fund Shares
ETF shares are bought and sold on an exchange, as the name implies. (The process has a lot in common with the way stocks trade.)
When the number of available ETF shares equals demand, an investor wishing to sell simply trades shares with someone looking to buy. (More on what happens when demand outstrips supply in a moment.) The stocks and bonds within the ETF are unaffected. And because there is no turnover in the holdings themselves, there is no taxable event.
Actively Managed ETFs
Actively managed ETFs are now on the same playing field as indexed ETFs. The Securities and Exchange Commission Rule 6c-11 now allows active managers to use optimized and custom or negotiated in-kind baskets for ETF creations and redemptions.
The rule seeks to provide more transparency to investors by requiring firms to provide historical premium, discount and bid/ask spread information on their websites. Additionally, it could further enhance the tax efficiency of transparent active ETFs by further enabling management of low-cost basis holdings.
By contrast, mutual fund purchases and sales take place between an investor and the fund company. When an investor (or advisor on their behalf) wants to sell mutual fund shares, the fund manager might have to sell some of the funds underlying stocks and bonds or reallocate the assets in the portfolio in response to the request. Such sales can create capital gains for the remaining shareholders.
What Happens When an Investor Sells Assets From a Taxable Investing Account?
2. ETFs Are Created and Redeemed More Tax Efficiently Than Mutual Funds
When an ETF is bought or sold and, as noted earlier, supply and demand aren’t equal, underlying shares get created or redeemed. An authorized participant (AP), an institutional investor contractually authorized to create or redeem shares directly with an ETF, performs the process. Creations and redemptions occur in units equal to a set number of ETF shares (for example, 1 creation unit = 25,000 ETF shares).
When creating ETF shares, the AP buys or borrows the pool of securities, known as the creation basket, that is defined as one creation unit and delivers it to the ETF issuer. Then, the AP receives ETF shares from the issuer that equal the total value of the securities. These transactions generally take place in-kind, on a one-for-one, fair value basis.
To redeem ETF shares, the process is reversed so that the ETF issuer delivers the redemption basket of securities from the ETF to the AP. This approach limits the need to buy or sell holdings within the ETF, which in turn reduces the amount of trading costs incurred by the ETF on creations and redemptions and importantly reduces the capital gains that would have been incurred to raise cash. In addition, any embedded gains follow the securities to the AP, helping significantly reduce the tax liability for existing shareholders.
In contrast, cash is the only way mutual fund redemptions are paid. A fund manager may have to sell securities to generate the cash needed to redeem the shares. In turn, all fund shareholders would have capital gains, even if they continued to hold the fund.
ETFs Give You More Control Over When (Not if) Taxes Are Paid
There’s no getting around paying taxes when profit is involved. Whether an investor sells mutual fund or ETF shares for more than the price paid, capital gains will apply.
But as with so many things in life, it’s all about using the right strategy at the right time. ETFs can work well for those staying invested, potentially reducing the tax effects so more investing dollars get put to work for the investor’s goals. Because everyone's situation is different, please consult a tax advisor who can help determine what is best for you.
Exchange Traded Funds (ETFs) are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.