What Makes ETFs Tax-Efficient?

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Whether you’re an investment expert or you’re new to the practice of investing, it’s important to consider the tax implications of your investments. ETF tax efficiency can be very high, which makes them a fantastic product to include in your portfolio.

Are you interested in using ETFs to save money on tax? Read on to find out more about ETF tax efficiency.

What Are ETFs?

An ETF (exchanged-traded fund) pools money from many investors and invests it in securities, including bonds, options, equities, and more. These funds are usually passively managed, which means that they track an index. Changes in the index determine which assets inside the fund are bought and sold, rather than relying on the decisions of an individual fund manager.

Equity ETFs may also track a particular industry, which means that the fund holds equities issued by businesses in that industry. That’s a great option if you want to support a particular sector that interests you, such as biotech.

How Do ETF Taxes Work?

You must pay taxes on the income you gain from ETFs, whether that income comes from interest, dividends, or capital gains from buying and selling.

The good news is that they can be more tax efficient than other types of investment, such as mutual funds.

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ETF vs. Mutual Fund Taxes

Mutual funds are taxed according to the same rules as ETFs. So why are ETFs more tax efficient than mutual funds?

The answer is that mutual funds are actively managed. Mutual fund managers buy and sell securities frequently, which leads to larger tax bills for capital gains.

If you want to reduce your investment tax bill as much as possible, then it might be worth prioritizing ETFs over mutual funds in your portfolio.

Capital Gains vs. Ordinary Income

Let’s take a moment to drill a little deeper into the term “capital gains.” When a security held within a fund (or any other asset) grows in value and then is sold, you have received a “capital gain.”

It’s a legal requirement to pay tax on capital gains, just like you have to pay tax on ordinary income.

The more buying and selling a fund manager does, the more taxable events occur. Therefore, you can pay a lot more in capital gains tax if you invest mostly in actively managed funds.

ETF vs. Mutual Fund: Tax and Other Considerations

In addition to their tax efficiency, ETFs have other important advantages over mutual funds. Let’s take a look at the key reasons to consider ETFs over mutual funds, besides simply paying less tax, although that in itself is a great reason.

ETFs are more transparent than mutual funds. You can view changes in your ETF holdings daily, whereas mutual funds only report their holdings once a quarter. If you are the type of investor who likes to know exactly where their money is invested, this could be a better option for you.

ETFs also offer greater liquidity than mutual funds. You can buy and sell holdings at any point during the day. In contrast, mutual fund shares can only be sold or bought at the end of the trading day. Most days, this won’t matter too much, but on those rare days where market prices rise or fall significantly during a single day, it’s a big deal!

You’ll usually also get lower expense ratios with ETFs than with mutual funds. Why not keep more of your money by minimizing expenses as well as taxes?

Is ETF Trading Right For You?

ETFs can provide many benefits if you include them as a part of your overall investment strategy. These funds are designed to help individual investors pay less tax than they would on other types of funds.

In addition to ETF tax efficiency, you can benefit from the diverse holdings included in ETFs. This diversity allows you to invest across industries, asset types, and even countries. Just like in life, diversity is a good thing. It allows you to create a balanced portfolio, which can help to limit your exposure to risk.

Remember, all investments are riskier than holding your money in a bank account. However, they also offer the opportunity to earn a much greater return than even a high-yield savings account can offer. Most people benefit from investing as a way of putting aside money for their long-term future.