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Not All ETFs Are Tax-Efficient Anymore

It used to be simple. One reason to consider investing in exchange-traded funds (ETFs) was that you would make out better at tax time than if you put your money into standard index mutual funds. But as ETFs have thrived, with exponential growth since their debut two decades ago, they’ve branched out from stocks to bonds and now to commodities and currencies. While those more esoteric ETFs provide a convenient way for ordinary investors to participate in hard-to-tap markets, they also bring tax complications that can hit you hard even if you hold on to your shares.
Standard equity ETFs resemble index mutual funds, in that both may be designed to track a stock benchmark. But when investors redeem mutual fund shares, the fund manager may need to sell holdings to come up with the cash, and that can generate taxable capital gains that the fund passes on to shareholders. ETFs, in contrast, are more like stocks; they’re traded on exchanges, and most transactions involve existing shares. So, there’s less selling of the assets in the fund and fewer immediately taxable gains, though you’ll still owe taxes if you sell your shares at a profit.
Many newer ETFs, however, are tied to the value of commodities or currencies, and those may be taxed in many entirely different ways. Such funds are often organized as trusts or limited partnerships, complicated structures that may generate several kinds of taxes. And these ETFs can own a very wide range of assets, from actual currencies and commodities to all kinds of derivatives—futures, forward contracts, options—that may be subject to various levels and timing of taxes. In many cases, you end up paying more than the 15% rate that applies to long-term capital gains of stock ETFs and mutual funds.
Sometimes, you’ll even be taxed on gains the fund hasn’t realized. The IRS may require a commodities fund that holds futures contracts, for example, to “mark to market” its positions in those contracts at year’s end— and you may be responsible for gains that don’t yet exist. You could also be on the hook if you own shares in a gold ETF that holds bullion or gold coins. Shareholders of those funds are subject to a tax on “collectibles”—at a 28% rate for long-term gains. The earnings of currency funds, meanwhile, may be taxed as interest, at ordinary income rates of as much as 35%.
In most cases, potential tax liability shouldn’t be a deal-breaker when considering an investment. Yet it is a consideration, and it’s a factor we look at when working with clients to construct investment portfolios that fit their financial goals, investing timetable, and investment risk-tolerance. If you wonder whether ETFs belong in your investment mix—and what kind of taxation you might face—please make an appointment so we can discuss these issues.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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