ETFs and Taxes
By Melanie G. Rogers
Think Glink Associate Editor
Summary: Exchange-traded funds, or ETFs, are often based on a stock or another index and so are not actively managed. With passive management, an ETF has less trading activity, so there are fewer taxable events. ETF investors benefit from this approach because they may pay fewer taxes.
If you're new to investing in exchange-traded funds, you may not be aware of all the benefits. Among them: lower taxes.
ETFs are basically mutual funds that are traded like stocks. Similar to regular mutual funds, which hold shares of multiple companies, ETFs contain shares of a variety of companies.
"Generally, because there is almost no trading, it means there's very little if any capital gains -- [ETFs] tend to be very tax efficient," says John Wasik, coauthor of "iMoney: Profitable ETF Strategies for Every Investor."
"The vast majority of ETFs are based on stock, bond or other sorts of indexes," Wasik says.
Most ETFs are passively managed because they're based on an index; thus, trading is minimal. Indexes used for ETFs include the Standard and Poor's 500 and the Wilshire 5000. Some ETFs, such as the Vanguard Energy ETF (VDE), follow industry-specific indexes. The VDE seeks to replicate the Morgan Stanley Capital International (MSCI) U.S. Investable Market Energy Index.
"Generally, for a stock index fund, your liability will be very low, much less than for an actively managed mutual fund," Wasik says.
But this may be changing. Many newer ETFs are actively managed. Wasik explains: "There's a new kind of generation of actively managed ETFs. They just came out a couple of months ago. The jury's out if they offer any advantages. It's too early to tell."
Before buying an ETF, check whether it's actively or passively managed and read the prospectus to get a sense of the tax implications. You may also want to contact an accountant.
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