Listen to The ETF Store Show every Saturday at 4pm on KCMO Talk Radio 710AM as we cover everything you need to know about Exchange Traded Funds and the world of investing.
On our most recent radio broadcast, with tax day 2012 looming, we explained how ETFs can reduce your tax bill. Because of their legal structure and minimal trading, ETFs typically distribute very little, if any, capital gains to investors. In contrast, many mutual funds distribute capital gains – sometimes even if the mutual fund is down for the year!
So, why is this case? Take the following example: Let’s say there’s a mutual fund shareholder that wants to sell their mutual fund shares because they need cash to buy a house. The mutual fund manager may need to sell shares of stocks held by the fund to raise cash to meet this shareholder redemption request. When the mutual fund manager sells shares of stocks owned by the fund for a gain, the mutual fund is required to distribute those gains to all mutual fund shareholders. So to recap, if you’re a shareholder of the mutual fund and another shareholder redeems their mutual fund shares, you may be penalized with a taxable capital gain distribution even though you didn’t do anything. That hardly seems fair. And what’s worse, these capital gain distributions are “phantom gains” in that the share price of a mutual fund is reduced by the amount of the capital gain distribution. So net-net, shareholders haven’t gained anything other than a tax bill.
Contrast that with ETFs where a shareholder wanting to raise cash can simply sell their shares on the stock exchange with no impact to you. There are instances where ETFs may reconstitute or rebalance holdings, thus generating a capital gain distribution, but those instances are rare. Recent data from Morningstar on capital gain distributions showed that over the last five years, looking at the large blend fund category, active mutual funds paid out capital gain distributions equal to 1.92% of the fund value while ETFs paid out 0%. That’s a big difference come tax time.
We also discussed tax loss harvesting strategies with ETFs and talked about some portfolio construction considerations when using exchange traded products. Listen to the full show here to learn more about reducing your taxes by using ETFs.
Podcast: Play in new window | Download
