Addressing the Taxman with the Tax Efficient Structure of ETFs

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By Sandra Testani - September 2019

In this world, nothing can be said to be certain except Death and Taxes.

Benjamin Franklin

We often refer to this famous quote to illustrate the near certitude that taxes impact everyone’s life. While people are right about the inevitability of taxes, what the quote misses is how their importance can ebb and flow in the minds of investors.

After a decade of positive market returns following the financial crisis, many investor portfolios have had significant capital gains to contend with. This was particularly painful last year when after a difficult fourth quarter, some mutual fund investors saw negative year over year returns yet still found themselves paying a capital gains tax. Coupled with recent changes to various income tax laws many individuals have refocused their attention on achieving tax-efficiency in their investments. Exchange traded funds (ETFs) have grown significantly, thanks in part to their tax benefits.

ETFs Key Features Lead to Improved Tax-Efficiency

ETFs are generally more tax efficient compared to traditional mutual funds. ETFs and mutual funds are both subject to capital gains tax and taxation of dividend income. However, ETFs have two features that reduce their exposure to events that trigger capital gains, enabling ETFs to generate less tax liability versus a similarly structured mutual fund.

Buying and Selling

First, as the name implies ETF shares are bought and sold on an exchange, similar to how stocks are traded. This means when the number of ETF shares available equals the demand from buyers, an investor wishing to sell simply trades shares with someone wishing to make a purchase. In this example, the underlying stocks and bonds are unaffected, so no turnover has occurred and thus there is no taxable event.

By contrast, mutual fund purchases and sales take place between an investor and the fund company.  When a client wants to sell mutual fund shares, to accommodate the client’s redemption the manager may have to either sell some of the fund’s underlying stocks and bonds or reallocate the assets. These sales may create capital gains for the remaining shareholders. These gains are taxed, even if an investor hasn’t realized those gains within his/her personal portfolio. This is how investors can experience negative year over year returns and still have to pay a capital gains tax.

What Happens When an Investor Sells Assets From a Taxable Investing Account?

What Happens When an Investor Sells Assets From A Taxable Investing Account Example

Creating and Redeeming

The second feature is the creation/redemption mechanism. At times, the number of ETF shares outstanding may need to increase or decrease to meet demand. In this case an Authorized Participant (AP) steps in. APs are institutional investors contractually authorized to create or redeem shares directly with an ETF. These transactions generally take place “in-kind.” In these exchanges, shares of the underlying stocks and bonds are delivered to or from the ETF instead of cash, which limits the need to buy or sell within the ETF itself. This ability to identify and deliver shares with embedded gains to meet redemptions can significantly reduce the tax liability for existing shareholders.

In contrast, mutual fund redemptions are only delivered as cash. A fund manager who has to sell securities to generate the cash needed to redeem the shares may generate capital gains for all fund shareholders.  

Taxes Will Be Paid

As Ben Franklin’s quote implied, taxes will eventually be paid. If the sale price is higher than the purchase price, both mutual funds and ETFs will be subject to capital gains when investors sell their shares.  Informed investors, however, can choose an investment vehicle, such as an ETF, that may potentially reduce the amount of tax that might need to be paid while they remain invested.

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Sandra Testani
Sandra Testani

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      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.

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