Olde Hornet
Well-Known Member
http://www.schwab.com/insights/personal-finance/etfs-are-they-always-tax-efficient
Mutual funds—especially actively managed stock mutual funds—are often tax inefficient. This is because most buy and sell stocks frequently, and they have to pass on any profits from those trades to their shareholders in the form of a capital gains distribution. As a shareholder, you pay taxes on those distributions.
But what about exchange-traded funds (ETFs)? They certainly have a reputation for tax efficiency. And overall, compared to most actively managed mutual funds, stock ETFs do tend to be much more tax-efficient. So why is that the case, and what are the exceptions to this rule?
Most ETFs track indexes
If your fund aims to match the performance of an index, especially a traditional market-capitalization-weighted index (where the biggest companies by market value have the most weight), that fund doesn’t need to do a lot of trading. It’s simply mimicking the holdings of an index, which don’t change frequently. This means fewer opportunities for the ETF to sell a stock for a gain, and by extension, fewer chances that you’ll have to pay taxes on those gains. (Note that index mutual funds tend to be tax-efficient, too, for the same reasons.)
Mutual funds—especially actively managed stock mutual funds—are often tax inefficient. This is because most buy and sell stocks frequently, and they have to pass on any profits from those trades to their shareholders in the form of a capital gains distribution. As a shareholder, you pay taxes on those distributions.
But what about exchange-traded funds (ETFs)? They certainly have a reputation for tax efficiency. And overall, compared to most actively managed mutual funds, stock ETFs do tend to be much more tax-efficient. So why is that the case, and what are the exceptions to this rule?
Most ETFs track indexes
If your fund aims to match the performance of an index, especially a traditional market-capitalization-weighted index (where the biggest companies by market value have the most weight), that fund doesn’t need to do a lot of trading. It’s simply mimicking the holdings of an index, which don’t change frequently. This means fewer opportunities for the ETF to sell a stock for a gain, and by extension, fewer chances that you’ll have to pay taxes on those gains. (Note that index mutual funds tend to be tax-efficient, too, for the same reasons.)