Can you use ETFs to pay less taxes on your investments? How to investment more tax efficiently.
The exchange-traded fund industry has been booming for the past few years. Much of these gains in assets have come at the expense of old-school mutual funds. Some investors have transitioned to ETFs because of lower expense ratios when compared to similar mutual funds. Many wealthier Americans have been guided towards ETFs for their tax efficiency.
Generally speaking, ETFs are more tax-efficient investment vehicles that incur fewer capital gains disbursements than your mutual funds. As a financial planner who loves tax planning, being more tax efficient with your investments is essential to improving net after-tax investment returns without necessarily taking on more investment risk.
When you sell a mutual fund, the fund manager is forced to sell securities in their portfolio to raise cash to fund your redemption. Whereas when you sell an ETF, you sell that investment bucket (within the ETF) to another investor. With the ETF, there is no taxable sale of the underlying holdings. You will still have capital gains (or capital losses) on the sale of the whole ETF.
When an investor exits a mutual fund, the fund’s manager must sell securities to raise cash for redemption. The same investor leaving an ETF can sell their shares to another investor, meaning neither the fund nor its manager has made a taxable transaction.
In 2021, the ETF industry took in about $500 billion of new assets when looking at asset flows. On the flip side, the mutual fund industry lost around $362 billion. While I do see the shift toward ETFs continuing, I don’t think mutual funds are going away any time soon. Many Americans own mutual funds within their workplace retirement plans. For…