Why ETFs Are So Tax-Smart

Investors are finding out how expensive regular mutual funds can be. Find out why ETFs can be a smarter choice.

Feb 22, 2014 at 3:04PM

You've probably heard that exchange-traded funds or ETFs have tax advantages over regular mutual funds. But to make the most of the advantages of ETFs, you need to understand why they're so tax-smart for your portfolio.

In the following video, Dan Caplinger, The Motley Fool's director of investment planning, explains the tax benefits of ETFs. He notes that traditional mutual funds often have high turnover, with active managers buying and selling shares and generating capital gains that they're required to pass on to shareholders. By contrast, SPDR S&P 500 (NYSEMKT:SPY), Vanguard Total Stock (NYSEMKT:VTI), and many other ETFs track popular indexes that don't have nearly the turnover that an active fund has. Dan reminds investors that you'll still pay income tax on dividend distributions, with popular dividend ETF iShares Select Dividend (NYSEMKT:DVY) passing through dividend income along with most other ETFs, including the two mentioned above. Dan concludes that ETFs have special characteristics that make it easier for them to avoid unnecessary tax liability, which is valuable for investors seeking the highest after-tax returns they can find.

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Dan Caplinger owns shares of iShares Select Dividend. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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