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Tax Day is in the rearview mirror, but taxes are always present, meaning it’s always a good time for advisors to illuminate clients to tax-advantaged strategies. Exchange traded funds are part of that conversation.
Tax advantages are among the biggest reasons why ETFs have pilfered so much market share from actively managed mutual funds over the years. Thing is many clients aren’t aware of the tax benefits associated with ETFs and that’s more true for older demographics that widely embraced mutual funds.
Many baby boomers and those in the so-called silent generation are apt to have fewer ETFs in their accounts. Some of that is attributable to those generations being groomed on mutual funds and some of it has to do with some older investors erroneously viewing ETFs as complex. As advisors know, that’s not the case and that thinking can force investors to miss out on some of the advantages associated with ETFs.
Tax perks are also one of the reasons why so many familiar mutual fund sponsors are converting some of their well-known funds to the ETF wrapper in an effort to attract and retain business from advisors and retail investors.
Consider Capital Gains
One of the primary tax drawbacks associated with actively managed mutual funds is the variety of ways in which investors can be stuck with burdensome capital gains obligations.
“With a mutual fund, capital gains can be generated in three ways: active management, rebalancing or redemption. All three require a profitable sale of mutual fund shares. When mutual fund shares are sold, the fund also sells the underlying securities,” notes WisdomTree’s Vanya Sharma. “By law, the possible capital gains generated from these sales have to be distributed immediately and are taxable.”
Conversely, the vast majority of ETFs, even the ones that are actively managed, don’t distribute capital gains. In any given year, it’s typical for most ETF issuers to tell advisors and investors that 95% or more of their products didn’t distribute capital gains for that year. Those lofty percentages are annual occurrences, confirming the tax benefits of ETFs.
“Capital gains with an ETF occur only if there’s been an appreciation of the ETF’s price. If there has been no positive price gain, then an investor can exit out of an ETF without any tax consequences,” adds Sharma. “This is true as long the sale does not impact other shareholders, which is less likely to happen because of how liquid most ETFs are and because the sale trade would have to be significantly block-size.”
Talking Tax-Loss Harvesting
In simple terms, tax-loss harvesting is the act of selling a losing position to offset capital gains liabilities incurred when realizing profits on a winning position. It’s a strategy advisors should be deploying and one that’s efficiently realized via ETFs.
The thing is with tax-loss harvesting, the user of the strategy must avoid the IRS’s wash sale rule, which stipulates when a losing position is sold, the proceeds cannot be directed to a security that’s “substantially identical” to the sold asset. As Sharma points out, ETFs can help on that front because market participants can avoid running afoul of wash sale regulations by using mutual fund, stock and ETF to ETF transfers.
“Mutual fund investors can sell a mutual fund at a loss and buy an ETF with similar, or even exactly the same, holdings, and the wash-sale rule would not apply,” she observes. “Similarly, investors looking to take advantage of tax losses on a stock or a number of stocks can look for an ETF that holds the same security or has exposure to the same market sector. After 30 days, the ETF could be sold and the stock repurchased.”