ETFs are relatively tax-efficient investments, especially when compared to actively managed mutual funds. One reason is that ETFs do not have to redeem shares for cash when you want to sell, as
open-end mutual funds must do. That reduces
portfolio turnover.
Limiting short-term
capital gains
— which are taxable at your regular income tax rate — and eliminating what are known as
phantom gains, or fund earnings on which you may owe tax but which were accrued before you purchased your shares.
Large
shareholders
who can exchange their ETF shares for the underlying securities, or vice versa, are conducting in-kind transfers, which don't produce capital gains either.
Of course, if you own an ETF in a taxable account, you may owe tax on any capital gains you realize if you sell your shares. You'll also owe tax on any investment income, though qualified
dividends
may be taxed at the lower long-term capital gains rate. And although it occurs relatively infrequently, you may also realize capital gains when the fund updates its portfolio to reflect changes in the index it tracks.
Tax time
It's up to you to decide when to sell your shares of ETFs and mutual funds. And sometimes timing makes all the difference. For example, you may want to sell shares late in the year and use a potential
capital loss
to offset gains. Or you might decide to postpone a sale on which you'll realize gains until the next tax year. What you can't control is the sale of assets within either type of fund, which could produce capital gains.
Large
