Are You Paying Your Neighbor's Taxes?

While the über wealthy use exotic tax strategies to exploit esoteric loopholes, the everyday investor has one great tax trick available in the form of exchange-traded funds. ETFs offer a type of modern-day tax miracle. Sure, when it comes to capital gains from the sale of an ETF, investors must give Uncle Sam his slice of the pie. But as a highly tax efficient long-term investment vehicle, ETFs have a sophisticated architecture that, when it comes to taxes, leaves their mutual fund brethren looking a bit haggard.

The tax basics. First, some tax basics for all types of funds. When you make a profit, you have to pay the government in the form of the capital gains tax. Capital gains rates differ depending on whether the asset is held less or more than a year, creating short- or long-terms gains. These tax rates vary depending on an investor’s income level, but generally, federal tax rates under the Bush-era tax plan can be as high as 15 percent for long-term and 35 percent for short-term capital gains. State taxes also apply.

Most ETFs also generate dividends, which are taxed. By meeting a specific set of holding criteria, long-term ETF investors will predominantly enjoy qualified dividend tax rates up to 15 percent with the exception of funds that track real estate investment trusts (REITs), which are unfortunately taxed as ordinary income. While both ETFs and mutual funds can generate capital gains, the tax implications of each are significantly different.

How mutual fund taxes work. Imagine that everyone in your neighborhood filed a joint tax return. What if your neighbor, Joe, happened to sell his business and you were required to pay a portion of his tax? Not acceptable, you would say.

Unfortunately, that is how mutual fund investing works. If one investor in the fund sells his position, the fund manager must sell underlying stock to give that investor his money back. That underlying stock may have a very low tax basis because it was added to the fund years before you ever invested. As a participant in the fund, you get hit with a portion of the tax consequence of the other person’s sale.

This mutual fund tax bomb grows daily and will eventually explode when rebalancing and redemptions force these low cost-basis shares to be traded. There have been instances where a mutual fund manager has held an underlying equity for years, accruing significant capital gains, only to eventually sell and foist a portion of the tax burden onto the new shareholder who just entered the fund.

That’s why looking at a mutual fund’s published performance is an inadequate measure for an investment decision. And unfortunately, there’s little visibility of the size of the boat anchor the fund is dragging in the form of excess taxes.

How ETF taxes work. ETFs are like mutual funds in that investors buy a broad range of underlying equities in one purchase, but they differ in that they are traded like a stock throughout the trading day. Capital gains taxes must be paid on ETF profits as well, but with a significant twist.

Although quite technical, simply put, ETF shares are created through an intermediary, a type of middleman that stands between the individual investor and the ETF provider. The ETF provider engages in “in-kind” transactions, trading baskets of securities for very large blocks of shares with the middleman.

As individual investors buy and sell shares of an ETF, a super-computer enabled arbitrage happens between the ETF provider and the middleman in the blink of an eye. Your shares are combined with the shares of other buyers and sellers that are traded for the underlying equities with the fund itself. In this way, individual investors never directly buy underlying taxable shares. This method allows the ETF provider to manage the tax bill for investors. In fact, this methodology is so effective that it is rare for an ETF to generate any taxable income at all.

Additionally, the cost basis of the underlying equities within the ETF is constantly being reset upward and at arms length from the individual investor. The result is wonderful. The ETF behaves like an individual equity in terms of taxes, but enjoys the diversification of a mutual fund–the best of both worlds.

For these reasons, ETFs are growing. In 2008, Morningstar conducted a survey on capital gains distributions for ETFs across 27 broad-based indexes over 5-, 10- and 15-year time horizons. The study showed only two ETFs made capital gain distributions over the past five years while just one ETF made distributions over the past 10 years.

As an example of their lower capital gains structure, iShares compared its ETFs with actively managed mutual funds in multiple categories over 10 years (2000 through 2009). The iShares Russell 1000 Growth Index Fund (IWF) had a capital gains rate of zero percent compared with 2 percent for the average, actively managed U.S. large-cap, open-end growth fund over that period. The iShares Russell 1000 Value Index Fund (IWD) also had a capital gains rate of zero percent compared with 2.9 percent for the average, actively-managed, open-end U.S. large-value fund over the decade.

Dumping your old mutual funds in favor of the more sophisticated and tax-efficient architecture of ETFs is like tossing out the old Motorola flip phone in favor of a new, 4G smartphone. The technology is simply better. Along with low fees and reliable performance, tax efficiency is another reason to get on the ETF bandwagon. You will be glad you made the change.