ETFs that use an indexing strategy are very tax-friendly in that they produce little year-to-year tax liabilities to their shareholders. This is a particularly significant matter for people who hold their investments in a taxable account. When, besides never, does it make sense for a long-term shareholder to get nabbed with yearly capital gains?
Building a portfolio of index ETFs and making it a portfolio’s core or foundation enables investors to avoid unnecessary taxes.
One final tip is to check a fund’s tax-cost ratio at Morningstar and compare it against a similar ETF. The tax-cost ratio measures how much of a fund’s annualized return is reduced by the taxes investors pay on distributions. For example, if a fund has a 1 percent tax-cost ratio over a three-year period that means investors in that fund lost 1 percent of their assets to taxes on an annualized basis.
Conclusion
ETFs are great tax planning tools, but it’s important to remember they don't avoid taxation on dividends or income. Rather, an ETFs’ tax advantage is due to their “in-kind redemptions.” After an ETF receives investor redemptions, the fund can deliver a basket of the fund’s underlying securities instead of cash. The fund can also pick and choose which shares to distribute, removing securities with the highest embedded capital gains. Because the trade conducted by the ETF is “in-kind,” no capital gains are realized, thereby averting taxes.
In the end, ETF shareholders are the winners.
Ron DeLegge is founder and chief portfolio strategist at ETFguide.