Many advisors tout the tax efficiency of exchange-traded funds to their clients.
The tax efficiency of ETFs comes from the way capital gains are handled within the fund, said Claudia E. Mott, a CFP and principal at Epona Financial Solutions in Basking Ridge, N.J.
Although mutual fund managers create capital gains that are passed on to investors when they sell securities to meet redemptions or rebalance the fund’s holdings, because an ETF is like a stock, no redemptions occur if a large number of investors sell their holdings. However, if a security in an ETF needs to be liquidated in an in-kind exchange, that can be used to minimize the capital gains.
But advisors should also let clients know that when they sell a mutual fund or ETF they may incur another form of capital gain, either short- or long-term, if their security has appreciated from the time it was purchased, Mott said.
The calculation of this gain is no different between the two investments.
“ETFs are more tax-efficient than open-end mutual funds, because they typically do not generate capital gains distributions from trading activity inside the fund,” said James J. Bruyette, managing director at Sullivan Bruyette Speros & Blayney in McLean, Va.
“They also easily lend themselves to tax-loss swaps, which involve selling one fund with an unrealized loss and immediately purchasing a second fund that pursues a reasonably similar but not identical strategy,” he said. “These swaps allow the client to recognize a tax loss without materially changing their investment strategy.”
Wade Balliet, senior vice president and head of investment advisory and management at Bank of the West’s Wealth Management Group in Denver, said that his team uses ETFs as a supplement to the firm’s active managers for asset classes for clients who don’t want exposure to year-end capital gains distributions that come with an active mutual fund.
“Additionally, we can use a number of approved ETFs for tax-loss harvesting -- selling stocks that have negative returns for the year -- selling the stocks to realize the loss and buying an ETF to maintain exposure in the portfolio until the 31 days have passed,” he said.
Michael T. McKevitt, a CFP and planner at Guillaume & Freckman in Palatine, Ill., said that his firm uses ETFs “proactively” throughout the year for clients who are above the 15% tax bracket “where the gains actually matter, and especially for those whose joint income is above $250,000
that triggers the [Affordable Care Act] surtax.”
“This year worked out even better than usual, as we took losses in individual energy companies and bought the energy ETF,” he said. “In many cases, we were buying the stock back much cheaper than when we had sold [it], while the ETF didn't perform as poorly during that time period.”
Katie Kuehner-Hebert is a freelance writer in Running Springs, Calif. She has contributed to American Banker, Risk & Insurance and Human Resource Executive.
This story is part of a 30-30 series on smart ETF strategies.
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