ETFs are more tax efficient than mutual funds

Mall investors, old and new, have been attracted to exchange traded funds for the tax efficiency of the investment vehicle.

Compared to traditional mutual funds, ETFs are more tax-efficient investment vehicles that result in fewer capital gains payouts, writes David Rae, Certified Financial Planner, for Forbes.

“As a financial planner who loves tax planning, being more tax efficient with your investments is key to improving after-tax net investment returns without necessarily taking on more investment risk,” Rae says.

Specifically, when an investor sells a mutual fund, the fund manager is forced to sell securities in the portfolio to raise funds to fund the sudden redemption, triggering a taxable event. By comparison, when an investor sells an ETF, they are selling that investment tranche, or the shares of the ETF, to another investor in the open market, so there is no taxable transaction of the underlying assets.

Nevertheless, ETF investors still face capital gains (or losses) on the sale of the entire ETF.

The tax-advantaged nature has helped many investors, especially those who have become dissatisfied with their mutual fund holdings. In 2021, the ETF industry attracted around $500 billion in new flows. In contrast, the mutual fund industry recorded outflows of approximately $362 billion. While ETFs continue to chip away at mutual funds, the traditional fund industry is not dead.

“While I see the transition to ETFs continuing, I don’t think mutual funds are going away anytime soon. Many Americans own mutual funds as part of their retirement plans at work or even a Cash Balance Plan, tax efficiency is not an issue for the underlying investments,” adds Rae.

Additionally, Rae warns that mutual funds come with so-called phantom income, where investors can lose money in a mutual fund and still see substantial capital gains taxes. As other mutual fund investors sell stocks, other owners are exposed to capital gains distributions throughout the year.

“In this scenario, you could almost think of it as playing hot potato — someone ends up with the proverbial bag of hot potatoes — capital gains,” Rae says.

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