What Makes ETF’s Tax Efficient?

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By Guest Author Greg Simmons

In the grand scheme of things, ETFs are relative newcomers to the financial world, but they are fast becoming a popular component to many investors’ portfolios. This is primarily because of the excellent diversity offered by these funds, but another attraction is their potential for excellent tax efficiency, and the fact that annual management fees are relatively low. This is especially true when you compare ETFs to mutual funds.

ETF Classification

One of the main factors that benefits ETFs is that they are generally classified as trusts, meaning the ETF is entirely its own entity; it is essentially an investment company in its own right, and therefore buying and selling the ETF is just like buying and selling another company.

The process of creation and redemption is what sets ETFs apart, and makes them particularly tax efficient. This procedure means that investors can avoid a considerable chunk of capital gains tax, by masking it in the creation and redemption process. ETFs are generally open ended funds, which means that authorized participants may trade assets in exchange for shares or vice versa.

What this means is that shares which were acquired at varying values, meaning there are some being held at profit and some at a loss, can be used to manipulate capital gains. Shares with a higher cost basis can be exchanged at a capital loss, which can neutralise unrealised gains, helping to avoid a good deal of capital gains.

The main point to consider is that when ETFs redeem their investor’s capital, they do so as an exchange, unlike mutual funds which do so in cash terms. Exchanges are not subject to tax, which is what makes ETFs so effective in this respect. Hiding capital gains is what this system is all about.

The key point to remember is that ETFs can fulfil investor redemptions without actually having to sell any securities.

ETFs vs. Mutual Funds

Of course, ETFs are not completely tax exempt, and it isn’t always possible to veil the capital gains through the creation and redemption process. This is the main component of an ETF’s operation however, so there is always scope for reducing tax.

When comparing mutual funds to ETFs, you’ll find that tracking identical indices can potentially yield 5% more of a tax burden, which could potentially mean thousands in lost profit on your typical sized portfolio. This does not include potentially higher management costs either.

ETFs Outside the US

In reality, ETFs are likely one of the most tax-efficient products on the US market, particularly when it comes to forex.

In the UK and other countries, ETFs are similarly popular, though they are not unique in their low tax. They also require offshore banking to fully take advantage of low taxation potential, due to corporation tax. Spread betting, classed as a form of gambling, is of course illegal in the US, but by the same token, is tax-free in the UK. Go to http://www.cmcmarkets.co.uk/spread-betting to find out more about spread betting if you reside in the UK.  Please know it carries considerable risk.

If you file taxes online there are some great web-based software packages available that will help you sort through the maze of tax related investment decisions.  I have found that TurboTax is the best.

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