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ETF Tax Considerations

ETFs are regarded as being tax-efficient to a great degree. Paying taxes on the acquired capital gains can be put off until the final sale of the fund, which is mainly caused by the way ETFs are created and redeemed. Paying taxes on capital gains is inevitable. However, it is recommended to delay it as much as possible so that the money you have free for investing will not be greatly reduced. The benefits an investor receives after-tax depend on several factors, such as:

  • The investor's marginal tax rate
  • Return on investment
  • The time the investment has been held

In terms of taxes ETFs are more beneficial than actively managed mutual funds. Additionally, they are slightly more advantageous than standard mutual funds and share almost the same benefits as tax managed index mutual funds.

If the value of a stock has increased in a standard mutual fund, the unrealized capital gains liabilities are accumulated. If it is sold, the mutual fund will distribute the capital gains to its shareholders keeping in mind the proportion of ownership.

An active mutual fund will lead to more taxes being paid to the IRS since more stocks will be bought and sold. This means that the turnover ratio will be higher. Under the conditions of a bear market when the prices of securities are decreasing, an active mutual fund investor will usually pay the tax bills of other investors. This is so since an investor that sells the mutual fund right before it makes distributions will not have to pay taxes, whereas the one that stays with the fund will have to pay Uncle Sam his fair share that is due on the whole amount.

ETFs are created through the so called in-kind trade by trading equivalent certificates. The tax benefits of ETFs come from the fact that the exchange of identical items doesn't require capital gains. However, capital gains are considered in standard mutual funds since they should acquire stocks on the open market for cash and the vice versa.

There are always exceptions from the general rule. In the case with ETFs, if the market is down, an ETF may have to pay high distributions, which will not be in tax advantage to the investors.

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