Death and Taxes: ETFs May Be Able to Help with One of These

Converting your SMAs or mutual funds to an ETF can help facilitate a greater potential tax efficiency.
 

Among the many potential benefits of the ETF structure, the one most often cited is their tax efficiency.  ETFs generally distribute fewer capital gains to their holders than mutual funds. Also, ETFs can give shareholders more time to defer taxes when potential tax implications may be realized.
 

Buying and Selling an ETF vs. a Mutual Fund

It’s important to remember that when investors buy into or sell out of a mutual fund, the fund’s portfolio managers must buy or sell stocks to accommodate that flow.

Within the ETF structure, investors buy or sell shares of the ETF in the open market. The creation/redemption process facilitates this workflow.
 

The Creation/Redemption Process

One of the potential tax benefits of ETFs are derived from the creation/redemption process. Authorized Participants (APs) are the only institutions that are allowed to create or redeem ETF shares. ETC’s portfolio managers engage with APs to facilitate the creation and redemption of custom baskets.

In-Kind Transfer

The delivery or receipt of securities to create or redeem the ETFs shares is known as an in-kind transfer, which facilitates another potential tax advantage offered by the ETF. Since trades are not occurring within the fund, there are no capital gains realized within the fund. The in-kind transfer is tax-free.

In contrast to the ETF, securities are traded within the mutual fund so all net capital gains must be distributed to shareholders.
 

Things to Consider

It is important to remember that while ETFs strive to be tax-efficient, there is no guarantee that they will be 100% tax-efficient. Despite best attempts, there may still be capital gains that need to be distributed at the end of a tax year.

Additionally, taxes are often deferred rather than eliminated. If the fund’s shares are appreciating, the holder may eventually need to recognize a capital gain at the time shares are sold. Within the mutual fund, the NAV is reduced by the capital gains when they are distributed, effectively distributing the tax burden over the life of the investor’s holding period. However, the ETF holder can choose when they realize that potential gain.
 

When deciding on an investment vehicle, investors must ultimately consider what is in their best financial interest. We believe that when coupled with other aspects, the potential tax efficiency of the ETF structure makes it an attractive vehicle for investors to consider when deciding on how they will execute their investment strategy.

If you’re already planning to invest money in a particular basket of stocks or bonds, why not create an ETF with ETC? Contact us to see if a mutual fund to ETF conversion is right for your business.