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The Tax Appeal of ETFs

“My taxes were higher in 2021, and year-end distributions from my mutual funds even increased my Medicare monthly premium,” an investor told us. “What happened? And what can I do to prevent this from happening again?”

2021 was a high-tax year for many investors who own mutual funds in taxable accounts, and these investors are now looking for ways to avoid a big tax surprise in the future. 

So let’s look at why fund investors paid more in taxes in 2021, why this may be different in 2022, and how exchange-traded funds (ETFs) may be one way to help reduce your investment taxes.  

Why fund investors faced higher taxes in 2021 & what to expect in 2022

Mutual funds are required to distribute the income they receive and capital gains they realize during the year at least once a year to their shareholders, and many funds made larger distributions to shareholders in 2021 than previous years. 

Mutual funds distributed $822 billion in capital gains to shareholders in 2021 more than double the $367 billion distributed in 2020 and far more than any recent year, according to data from the Investment Company InstituteMore equity funds made distributions in 2021 as well: 74% of US equity funds paid capital gains distributions in 2021 compared to 53% in 2020. 

Mutual fund capital gain distributions have been going up. Bar chart of distributions 2012 to 2021

Why did so many funds make distributions in 2021?

Most funds had big gains on the books from the market’s powerful rally off the March 2020 lows, and 2021 didn’t offer many opportunities for fund managers to realize losses that can be used to offset capital gains. Stocks rallied steadily in 2021, and the S&P 500’s largest decline was just -5% (in most years, the index has one 10% decline and often more). 

Fund distributions usually change from year to year, and so far 2022’s market declines so far have provided ample opportunity for investors to realize losses that they can use to offset taxable gains, but the large 2021 tax bills have led some investors to pay more attention to the potential tax burden of their investments, and that’s led many to focus on exchange-traded funds (ETFs). 

The tax advantages of ETFs

ETFs tend to be more tax efficient than traditional mutual funds because ETFs don’t usually make capital gains distributions (they typically distribute income dividends quarterly).

A 2022 Morningstar study found that “over the past 10 years, ETFs distributed capital gains far less frequently than mutual funds. Also, ETFs that did distribute gains tended to make much smaller payouts than their mutual fund counterparts.”

How ETFs typically avoid making taxable distributions

ETFs have a unique process for creating and redeeming shares, which typically leads to fewer distributions. Here’s how it works (and how it differs from traditional mutual funds):

When you buy or sell shares of a mutual fund, you trade directly with the fund company. When you buy a fund, the fund company issues new shares to you and puts your money to work; when you sell, the fund company retires your shares, selling securities, if necessary to meet the redemption. And any capital gains the fund realizes along the way are required to be passed along to shareholders as distributions. 

With an ETF, you’re trading on an exchange with other traders. You don’t deal directly with the ETF itself. 

ETFs have a third party (called an authorized participant or AP) that manages the supply of ETF shares on the market. The AP creates and redeems “creation units,” which are baskets of securities that approximate the ETF portfolio, and the AP exchanges these units with the ETF for shares. This exchange is called an “in-kind” transfer, which isn’t considered a taxable event, and this usually prevents shareholders from being on the hook for capital gains on an ETF’s individual securities.

As explained, “the ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden.”

WisdomTree published this useful graphic in its explanation of the tax benefits of ETFs

WisdomTree ETF creation and redemption process

Not all ETFs are tax efficient

Investors today have hundreds of ETFs to choose from, including ETFs that are designed to track some well-known mutual funds. But if you’re using ETFs in an effort to reduce your taxes, you’ll want to choose carefully because not all ETFs are tax efficient.  

Some ETFs, particularly precious metals, commodity, and currency ETFs, may have additional tax complications or be taxed at different rates. (Schwab has a good overview here.) Some ETFs, for example, are structured as partnerships and issue a Schedule K-1 at tax time, which can be a headache at tax time.

Tax-conscious investors should also remember that mutual fund distributions aren’t the only tax consequence of investing. When investors trade mutual or exchange-traded funds in a taxable account, they will owe taxes on any gains they realize along the way.

Owning ETFs is just one way to try to manage your investment taxes. At FundX, our investment advisers work to help their wealth management clients reduce their tax burdens and income tax planning is part of our financial planning process. Set up a time to talk with an adviser to learn more.

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