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.
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 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?