ETF Tax Efficiency

[ericd67]

I'm new to the forum and relatively new to index investing after having had a Roth mutual fund at Edward Jones for 15 years. I had watched my Edward Jones mutual fund over the years, contributing now and then, always noticing how it was a virtual mirror of the S&P 500 as far as performance. It always annoyed me that I had to pay a 5.75% sales charge but I just thought that's how it worked. One day I literally thought to myself "Too bad you can't just buy the S&P 500. It'd be nice to cut out the middleman." A google search and a lot of reading led me to index investing, and the lights started coming on! I learned about Vanguard, index investing, and asset allocation on my own and made the decision to do a transfer of assets to a Roth at Vanguard. I also learned that my 401k also offered Vanguard funds, and I transferred 90% of that money to a Vanguard Target Retirement fund and 10% to Wellington (I know Wellington is actively managed). The more I learned about index investing the more the math made sense to me. That's my story in a nutshell.

My question here is about ETF's and their tax efficiency. I'm looking to understand more about ETF's in general. Assume for now that this would be in a taxable account, since my Roth won't matter anyway, and my 401k would be taxable when I withdraw. I sort of understand the basic concept of the ETF and in-kind exchanges which can offset capital gains, but my question is more basic: If I buy a share of a hypothetical ETF today at $60 and sell it tomorrow for $62, what happens? Does it matter if it got to $62 from dividends or from market appreciation? I'm not too concerned about the underlying transactions that take place such as in-kind exchanges etc, I just want to know how it affects ME. I assume I will pay a capital gains tax on $2 since I would be actually redeeming the share...so how is it more efficient? The ultimate direction I'm going here is to consider further reducing expense ratio costs by shifting my mutual fund into an equivalent ETF. I am a long term investor, I would plan to hold the ETF until I retire. Thank you in advance.

[livesoft]

If you buy a share of an ETF @ 60 and sell at 62, you will have a $2 cap gain and pay cap gains tax on that gain.
If you buy a share of a fund @ 60 and sell at 62, you will have a $2 cap gain and pay cap gains tax on that gain.

Thus, there is no difference between a share of the ETF and the share of the mutual fund as far as this transaction is concerned.

You also need to know that there are various cap gains tax rates. Some folks will pay 0% rate, some 15% rate, some a marginal income tax rate, and some other rates. One needs to understand how capital gains are taxed. In particular, presently short-term capital gains are taxed as ordinary income, so one would pay marginal income tax rates on the gain, which could be 0% or could be 28%, 33%, or some other rate. Long-term capital gains are taxed somewhat differently, but generally at a lower rate than short-term cap gains. Thus, it pays to avoid short-term cap gains and only incur necessary long-term cap gains. And one needs to know that unrealized cap gains are not taxed.

As citizens of the US where we vote for reps who make tax laws for us, we all have the obligation to understand how we are taxed, so it is great that you are learning about all this.

[Khanmots]

I'm not too concerned about the underlying transactions that take place such as in-kind exchanges etc, I just want to know how it affects ME. I assume I will pay a capital gains tax on $2 since I would be actually redeeming the share...so how is it more efficient?

It's more tax efficient because of what happens when people buy and sell the share.

For a naively managed mutual fund... when someone buy a share they go out and buy a tiny bit of everything. When you sell the share, they sell off a little bit of everything. This creates capital gains within the mutual fund itself that get distributed... and you thusly get taxed on.

With an ETF when someone buys or sells a share they're buying/selling an existing share directly with someone else. So there's no underlying buying/selling of assets going on to generate taxable capital gains distributions.

Now, that said, most large mutual funds have all sorts of strategies in place for managing this and it's generally not a problem. But this is where "ETFs are more tax efficient" comes from. Personally I prefer the simplicity of mutual funds and only have one asset class where I use an ETF because the asset class inherently has high transaction costs and thus the ETF is significantly cheaper as it can avoid many of the transactions that a mutual fund can't.

[pkcrafter]

sort of understand the basic concept of the ETF and in-kind exchanges which can offset capital gains, but my question is more basic: If I buy a share of a hypothetical ETF today at $60 and sell it tomorrow for $62, what happens? Does it matter if it got to $62 from dividends or from market appreciation? I'm not too concerned about the underlying transactions that take place such as in-kind exchanges etc, I just want to know how it affects ME

.

Maybe this will help--

http://www.bogleheads.org/wiki/Tax_Basics

In your example, you would be taxed on short-term capital gains, which would be at your current tax rate. Wait one year and you would be taxed at long-term CG rate, which is 15% for most, except for those in the 15% bracket it is zero.

Vanguard's ETFs and funds are mixed with the same tax results. All ETFs are not equal though as tax-efficiency still depends on what the goal is and how the ETF is managed. For instance, a REIT ETF will not be tax efficient.

Paul

[grabiner]

It's more tax efficient because of what happens when people buy and sell the share.

For a naively managed mutual fund... when someone buy a share they go out and buy a tiny bit of everything. When you sell the share, they sell off a little bit of everything. This creates capital gains within the mutual fund itself that get distributed... and you thusly get taxed on.

With an ETF when someone buys or sells a share they're buying/selling an existing share directly with someone else. So there's no underlying buying/selling of assets going on to generate taxable capital gains distributions.

The main tax advantage of ETFs is somewhat different. ETF shares are created or redeemed in-kind; an institutional investor can ask to convert 100,000 shares of an ETF into the underlying stock or vice versa Since no stock was bought or sold in a redemption, this is not a taxable transaction to the ETF, but the ETF provider can choose to get rid of the lowest-basis shares of each stock it holds, reducing the capital gains that the fund will have to distribute.

With Vanguard, this isn't an issue; the ETF is a share class of the mutual fund, so they share the tax benefits. Very few of Vanguard's stock funds with an ETF class have distributed capital gains.

[RandyAdams1978]

I was wondering myself about ETF's. From what I see at morningstar.com, some Vanguard ETF's are not even as tax efficient as their mutual fund counterparts.

http://performance.morningstar.com/fund/tax-analysis.action?t=VTSMX&region=USA&culture=en-US

Go to the above link and then click on the 'Compare' tab. Type in the Vanguard Total Market ETF (VTI). Click 'Add'. Then look at the tax cost ratio comparison. The lower the number here, the better. The ETF is LESS tax efficient than the mutual fund.

There are at least several Vanguard ETF's like this.

[archbish99]

I was wondering myself about ETF's. From what I see at morningstar.com, some Vanguard ETF's are not even as tax efficient as their mutual fund counterparts.

http://performance.morningstar.com/fund/tax-analysis.action?t=VTSMX&region=USA&culture=en-US

Go to the above link and then click on the 'Compare' tab. Type in the Vanguard Total Market ETF (VTI). Click 'Add'. Then look at the tax cost ratio comparison. The lower the number here, the better. The ETF is LESS tax efficient than the mutual fund.

There are at least several Vanguard ETF's like this.

Of course -- you're comparing Investor shares to the ETF instead of Admiral shares. The Admiral shares will have the same capital performance and higher dividends, therefore you pay more taxes. That's not a reason to avoid them, any more than you avoid a raise to prevent your regular income taxes from going up. What you want to compare is after-tax return, not tax cost itself.

Compare VTSMX to VTI and VTSAX. They're all the same fund. You'll see that YTD is within a hair, because there have been no distributions. Starting with one-year performance, VTI and VTSAX are very similar, and both higher return (and thus higher taxes, but still higher after-tax return) than VTSMX.

Which points out that one key reason to use ETFs is if you don't have the $10k required to get into Admiral shares.

[RandyAdams1978]

I thought the tax efficiency part of it would be more earth-shattering. I was under-whelmed.

[archbish99]

Remember that, since the Vanguard ETFs are share classes of the mutual fund, the mutual funds benefit from the ETF advantage as well. So you won't see the ETF advantage when comparing a Vanguard ETF to the equivalent mutual fund. Try comparing VOO (Vanguard's S&P 500 ETF) and SWPPX (Schwab's S&P 500 fund). You'll see relatively minor differences in the pre-tax return (ERs are 0.05% vs. 0.09%), but a slightly larger difference in after-tax return over the last year (0.4%).

[Default User BR]

Which points out that one key reason to use ETFs is if you don't have the $10k required to get into Admiral shares.

Or you choose not to have Vanguard as your custodian, in which case Admiral class for index funds probably won't be available to you.


Brian