The exchange-traded fund industry has been booming for the past few years. Much of these gains in assets have come at the expense of old-school mutual funds. Some investors have transitioned to ETFs because of lower expense ratios when compared to similar mutual funds. Many wealthier Americans have been guided towards ETFs for their tax efficiency.
Generally speaking, ETFs are more tax-efficient investment vehicles that incur fewer capital gains disbursements than your mutual funds. As a financial planner who loves tax planning, being more tax efficient with your investments is essential to improving net after-tax investment returns without necessarily taking on more investment risk.
When you sell a mutual fund, the fund manager is forced to sell securities in their portfolio to raise cash to fund your redemption. Whereas when you sell an ETF, you sell that investment bucket (within the ETF) to another investor. With the ETF, there is no taxable sale of the underlying holdings. You will still have capital gains (or capital losses) on the sale of the whole ETF.
When an investor exits a mutual fund, the fund’s manager must sell securities to raise cash for redemption. The same investor leaving an ETF can sell their shares to another investor, meaning neither the fund nor its manager has made a taxable transaction.
In 2021, the ETF industry took in about $500 billion of new assets when looking at asset flows. On the flip side, the mutual fund industry lost around $362 billion. While I do see the shift toward ETFs continuing, I don’t think mutual funds are going away any time soon. Many Americans own mutual funds within their workplace retirement plans. For tax-deferred accounts like an IRA, 401(k), or even a Cash Balance Plan, tax efficiency is not an issue for the underlying investments.
Phantom Income from Mutual Funds
You can lose money in a mutual fund and still get hit with substantial capital gains taxes; this is called Phantom Income. As other investors sell their mutual funds’ shares, other owners can get hit with capital gains distributions throughout the year.
In this scenario, you could almost think of this as playing hot potato- someone gets left holding the proverbial bag of hot potatoes- capital gains. Vanguard funds were recently sued for the amount of capital gains a move it made created for owners of their Target Date funds in taxable accounts.
The capital gain distribution was 12.1% of fund assets in 2021. This resulted in substantial tax bills for many of the account holders.
ETF Tax Advantages versus Mutual Funds
It is rare for ETFs to pass along any capital gains to shareholders. Most active mutual funds will disperse capital gains each year. Before you run out and sell your highly appreciated mutual funds, look at the taxes you would incur to sell. If you have held mutual funds for long periods of time, you may have substantial embedded capital gains. In plain English, it could cost a lot of money to sell out of the funds.
If you have highly appreciated mutual funds, consider turning off the automatic reinvestment of capital gains and dividends. This will allow you to reinvest the future funds more tax efficiently in ETFs. The same would go for future contributions to your account being used to purchase ETFs rather than mutual funds in your taxable investment accounts.
While I don’t have a crystal ball, I do expect taxes to be higher in the future. As your income increases and as tax rates increase, the value of tax planning and tax-efficient investment grows exponentially.