Tax Advantages of Exchange-Traded Funds - dummies

By Russell Wild

Before there were exchange-traded funds (ETFs), individual securities had a big advantage over funds in that you were required to pay capital gains taxes only when you actually enjoyed a capital gain.

With mutual funds, that isn’t so. The fund itself may realize a capital gain by selling off an appreciated stock. You pay the capital gains tax regardless of whether you sell anything and regardless of whether the share price of the mutual fund increased or decreased since the time you bought it.

There have been times (pick a bad year for the market — 2000, 2008 . . .) when many mutual fund investors lost a considerable amount in the market yet had to pay capital gains taxes at the end of the year. Talk about adding insult to injury!

One study found that over the course of time, taxes have wiped out approximately 2 full percentage points in returns for investors in the highest tax brackets.

In the world of ETFs, such losses are very unlikely to happen. Because most ETFs are index-based, they generally have little turnover to create capital gains. To boot, ETFs are structured in a way that largely insulates shareholders from capital gains that result when mutual funds are forced to sell in order to free up cash to pay off shareholders who cash in their chips.