The IRS tax treatment of ETFs and Mutual Funds are the same. Both are subject to capital gains tax and taxation of dividend income. But the way ETFs are structured means taxes are minimized for the investor and the ultimate tax bill – after the ETF is sold and capital gains tax is incurred – is less than that of a similarly structured Mutual Fund.
Mutual Fund “pass through” occurs when a Mutual Fund makes trades throughout the year and generates either taxable gain and/or loss. Because Mutual Funds act as conduits for their holdings, this must be passed through to the individual investor. Often times, a Mutual Fund will pass through during the year and provide reporting to keep estimations accurate. However, sometimes a Mutual Fund does not pass through these gains and losses until late December, at the end of year. This results in erroneous estimations which often result in a much higher taxable gain than originally anticipated. This information is normally available on the 1099 from your portfolio. If your 1099 shocks you this year, let us review it for options to lower the tax impact in the future. All gains and losses in a portfolio occur on an annual basis, so it makes sense to identify problems with your portfolio before the end of the year when it’s too late to take action!
ETFs have the same “pass through” rules, however due to ETFs having alternative ways to fund new investments they do not sell as often as a Mutual Fund, resulting in a significantly lower capital gain pass through. There are ways to manage the portfolio to counter-act these unexpected gains, and proper planning to make your portfolio more tax-efficient can limit the amount of unexpected taxes you will pay to Uncle Sam.
Mutual Fund managers do take advantage of carrying capital losses from prior years, tax-loss harvesting, and other tax mitigation strategies to diminish annual capital gains taxes. Index mutual funds can be more tax efficient than actively managed funds because of lower turnover.
ETFs may be more tax efficient compared to traditional Mutual Funds with fewer “taxable events.” But there are many differences between ETFs and Mutual Funds, structuring, investment strategy, fees, as well as tax implications. Learn more here: https://www.fuoco.com/resources/tax-alerts/327-trends-in-trading-the-etf-vs-the-mutual-fund.
All investments have pros and cons. Everyone’s investment goals are unique – TFG’s 360 degree, “whole-istic” approach can help you reach yours. Feel free to contact me, Cory Lyon, directly at 561-209-1120, with any questions regarding financial investment strategies. At TFG, we believe in customized investment portfolio design and personalized asset management. I act as a fiduciary for all my clients.
TFG Financial Advisors, LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities, and past performance is not indicative of future results. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.
