Using ETFs to Avoid and Minimize Capital Gains Liabilities

EAdvisors and experienced investors know that exchange traded funds, in most cases, are much more tax efficient than actively managed mutual funds.

Much of the tax advantage of ETFs over mutual funds derives from the create / redemption mechanism used by ETFs. When mutual fund investors make redemptions, the shares held in the fund must be sold in order to raise cash to deal with that redemption, triggering a taxable event. This is not always the case with ETFs.

While this can be an “ETF nerd” trick for many investors, there are affordable ways for ordinary investors to further mitigate capital gains exposure when using ETFs.

“Another way to potentially reduce the impact is to invest in tax-advantaged exchange-traded funds (ETFs),” according to Invesco research. “The unique structure of index ETFs means that they don’t necessarily have to sell holdings to cover investors’ outflows (instead, they can use an ‘in-kind’ mechanism to create and redeem fund units) . In general, index ETFs can potentially distribute gains in rare circumstances, for example by significantly rebalancing a portfolio due to significant changes in its underlying index.

More good news for investors: Some of the more popular ETFs have a long track record of exempting investors from capital gains obligations. This group includes the venerable Invesco Trust QQQ (QQQ) and the Invesco S&P 500 Equal Weight ETF (RSP), the largest even-weighted ETF.

“Invesco has 191 ETFs that have paid no capital gains distributions over the past five years. And many, like Invesco QQQ, the Invesco S&P 500 Equal Weight ETF, and the Invesco Taxable Municipal Bond ETF, have never made any capital gains distributions in their lifetime, ”the issuer said.

Conversely, many mutual funds generate capital gains, and some of these tabs can be overwhelming for investors.

“In 2020, 57% of US equity mutual funds paid out capital gains distributions to their shareholders,” notes Invesco. “Over the past 10 years, the average annual distribution of US equity mutual funds has ranged from 4% to 8% of the fund’s net asset value. Paying taxes on these distributions can erode portfolio returns over time. “

Bottom Line: ETFs are more tax-efficient than mutual funds, and investors can amplify those benefits by deploying ETFs in tax-efficient retirement accounts.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.