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Portfolio > ETFs

Under the Hood: Tax Treatment of ETFs vs. Mutual Funds

By Mike Patton

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ETFs are more tax efficient than mutual funds,only one of the reasons ETFs have been gaining market share. Although I wouldn’t predict that mutual funds will go the way of the dinosaur, I will predict that as advisors come to better understand ETFs, they will become increasingly popular. In this article, we’ll take a look at the key reasons behind the tax efficiency of ETFs and how they compare to a typical mutual fund. 

Mutual Funds

To be taxed as a regulated investment company (RIC), mutual funds must meet several requirements. One of these is the requirement to distribute at least 90% of its income (excluding capital gains) to shareholders each year. However, to avoid a 4.0% excise tax on the under-distributed amount, IRS regulations require that mutual funds distribute 98% of their ordinary income earned during the year, 98.2% of its net capital gains earned during the period ending on October 31, and 100% of any previously undistributed amounts.

In practice, most mutual funds distribute 100% of income and capital gains each year.

Because a mutual fund is a pass-through entity, the shareholder is liable for any tax due on these distributions. This is why an investor should never invest in a mutual fund just prior to a capital gains distribution, which typically occurs in December.

In short, an investor in a mutual fund will be required to pay tax on all taxable distributions, even if the investor is reinvesting capital gains and dividends and even if the investor or fund experiences a loss during the calendar year. Much of this is the same with ETFs but there is one distinct difference. 

ETFs

ETFs have been capturing market share for quite a while. For example, by year-end 2003, the amount of assets in ETFs was $151 billion, representing just under 3.0% market share. As of June 2014, this had grown to $1.8 trillion, which was just over 12% market share. Although this is a significant growth, it’s still quite a bit below mutual funds which, as of the same June 2014 date, had about $13.1 trillion in assets.

That said, there are several reasons ETFs continue to win the popularity contest. In addition to daily transparency and intraday pricing, ETFs have a distinct tax advantage over mutual funds. Actually, there are a couple of reasons for this.

According to Jim Rowley, a senior investment analyst with Vanguard, “The overwhelming amount of an ETF’s tax efficiency is due to it being an index fund, and index funds are typically more tax efficient than active management.” 

Mr. Rowley also stated that over 90% of all ETFs are indexed. However, there’s another, more covert reason for an ETF’s tax efficiency: its structure, which results in fewer long-term capital gains distributions. How does this work? How does it differ from a mutual fund? 

ETFs Versus Mutual Funds: Taxation Overview

ETFs hold an advantage over mutual funds. Here’s where they are the same. Shareholders of both will pay any tax due on the income, dividends and short-term capital gains which are distributed. However, with an ETF, shareholders are much less likely to be subject to long-term capital gains. To understand why, we need to understand the structure of both of these instruments.

Referring to the illustration below, when a shareholder invests in a mutual fund, they do so by exchanging cash for shares of the fund. The fund will then invest the cash in stocks, bonds, etc. The key is that investors are making a cash-for-shares exchange directly with the fund.

Mutual Fund Structure

Conversely, when an investor invests in an ETF, the investor exchanges cash for fund shares, but the exchange is between an investor and an Authorized Participant (AP) and not directly with the fund.

To clarify this we must understand how the ETF shares are created (refer to Exchange-Traded Fund Structure below).

Shares in an ETF are created by an AP, which might be a market maker, a large investor, a specialist or an institutional broker-dealer. First, an AP will purchase a basket of securities through the capital markets which represents the holdings in the ETF. Then, the AP delivers the securities to the fund custodian in exchange for shares in the ETF, known as ETF Creation Units. This exchange is done “in-kind.”

Finally, the AP sells the shares to the investor. Because the exchange is considered to be in-kind and is between the AP and the fund custodian, the shareholder is less likely to be faced with long-term capital gains. Of course, when the shareholder ultimately sells the ETF, they will pay tax on the gain in the share price, if any.  

Exchange-Traded Fund Structure

Conclusion

As ETFs continue to grow in popularity, they should continue to capture market share. Despite the similarity in the taxation of mutual funds and ETFs, the structural difference and potential absence of long-term capital gains in ETFs makes them a compelling investment vehicle. Coupled with intra-day pricing, daily liquidity and transparency, as advisors learn more about them, ETFs may one day overtake mutual funds.

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See the entire lineup of ThinkAdvisor’s annual 22 Days of Tax Planning Advice: 2015

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