ETFs are revolutionizing the way we invest and the reasons for their popularity are not difficult to understand. They combine the flexibility, ease and liquidity of stock trading with the benefits of traditional index fund investing. Further, they are generally less expensive, more transparent as well as more tax-efficient than mutual funds.
Mutual funds are infamous for causing tax headaches to unsuspecting investors. ETFs on the other hand are tax smart due to the way they are structured. However, there are some ETF structures that are not very tax efficient and investors need to be aware of the issues associated with them.
ETF Structure Creates Tax Efficiency
Since most ETFs track well-known market indexes, they usually experience lower turnover compared with actively managed funds and thus create lower tax liabilities.
But more importantly, ETFs are generally more tax efficient compared with similar passively managed mutual funds, due to the way they are structured.
In other words, if an investor holds an ETF and a similar mutual fund in a taxable account, the ETF will most likely result in less tax liability for the investor.
The creation of an ETF begins with the sponsor, also known as the manager filing a plan with the SEC, and on approval of the plan executing an agreement with an authorized participant (AP), also known as a market maker or specialist. AP in turn assembles the appropriate basket of constituent stocks and sends them to a specially designated custodian bank for placing them in a trust.
The custodian forwards the ETF shares (which represent legal claims on tiny slivers of the basket of shares held in the trust) on to the authorized participant. This is a so-called in-kind trade of equivalent items and thus there are no tax implications.
On the other hand, when an investor purchases shares of a mutual fund, the mutual fund has to create new shares by actually buying the shares of the constituent stocks.
Similarly when an investor redeems his/her investment, the mutual fund has to sell the constituent shares.
The sale of stocks by the mutual fund (shareholder redemption or portfolio turnover) may create capital gains for the shareholders. So, the mutual fund investors may have to pay capital gains taxes even if they have unrealized losses on their investments.
According to WSJ, 26% of equity mutual funds paid out capital gains in 2011, compared with just 2% of equity ETFs.
ETFs are however not tax free. Dividends from ETFs are taxed like dividends from mutual funds or stocks. Capital gains at the time of sale also receive similar treatment.
But overall ETFs—in particularly stock ETFs--are much more tax-efficient than mutual funds and by creating lower tax liabilities, ETFs result in higher long-term returns for investors.
However not all ETFs are tax-efficient. Below we have highlighted some specific situations that can cause some headaches for investors.
Commodity ETFs that hold commodity futures (futures backed) are structured as “limited partnerships” and are required to report an investor’s allocated share of a fund’s income, gains, losses and deductions on a Schedule K-1 instead of 1099. These are somewhat difficult to handle.
Further gains or losses realized by ETFs are taxable events even without any distributions being paid to shareholder. These funds are subject to the so called “60/40” rule--60% of the gain is subject to the long-term gains rate and 40% to the short-term rate.
Precious Metals ETFs
Commodity ETFs that hold the precious metals (physically backed) like (GLD - Free Report) and (SLV - Free Report) are treated same as holding the bullion itself. These ETFs are structured as “grantor trust” for income tax purposes. Owners (shareholders) of the trust are treated as if they owned a corresponding share of the assets of the trust.
IRS treats precious metals as “collectible” for long-term capital gains and as such gains are taxed at the rate of long-term capital gains on collectibles if held for more than one year.
MLPs come with complicated tax issues and many investors avoid investing in them only due to daunting tax requirements. Thankfully for the investors, some of the tax complexities can be avoided by owning them in ETP form. The payouts by the ETPs are reported as ordinary income on Form 1099, and therefore the K-1 forms are not required.
Funds that have more than 25% of their assets invested in MLPs are treated as C corporations for tax purposes. Further, assets are required to be marked to market and a deferred tax liability for the unrealized gains needs to be recorded.
As a result, MLP ETFs have significant tracking errors. The most popular MLP ETF (AMLP - Free Report) has a gross expense ratio of 4.85% thanks mainly to deferred tax liabilities.
Some ETFs avoid these adverse issues by limiting their exposure to MLPs below 25%. ETNs also typically eliminate some of these complex tax consequences, as they do actually not hold any securities. But they come with credit risk of the issuer.
ETFs are generally "Extremely Tax Favorable" due to the way they are structured, but some ETFs are structured differently and have some tax issues that invetors should be aware of before they decide to invest.
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