Tax Benefits of ETFs

On our Exchange-Traded Funds (ETFs) discussion board the other day, Fool Community member smith107 asked: "What are the tax advantages (if any) of ETFs?"

He quoted an explanation he found at Yahoo! that said, "As luck would have it ETFs are also quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to pay most of his capital gains upon final sale of the ETF, delaying it until the very end. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth. Exactly how much an investor benefits after-tax depends on their marginal tax rate, the return of the investment, and how long they hold the investment. Overall, ETFs are similar to tax-managed index mutual funds, slightly more efficient than standard mutual funds, and significantly more efficient than actively managed mutual funds."

Smith107 rightly pointed out that this explanation left the matter rather murky, with the benefits dependent on many factors.

Fellow Community member jbking responded with his take, that it varies greatly, with some ETFs being better than funds and others being worse. He also sensibly noted that tax efficiency shouldn't be the only consideration: "Variable annuities are the master of tax efficiency since you don't pay taxes until withdrawal and thus if you absolutely loathe taxes these may make sense. However, as an insurance product these generally have higher fees than alternatives which may take some time to compensate for in the tax-deferral department." (Learn more in "The 'Criminals' Who Sell Annuities.")

Smith107 countered with another thought: "These ETFs are being promoted as a good way to invest -- but in the short term? I think not. The broker sites I've been accessing are promoting ETFs the same they promote DRIPs; i.e., you can invest small amounts of your money over a long period of time. Problem: Each time you do this, you pay a commission." [This is why it can matter a lot how much you pay in commissions. Did you know some brokerages charge $5 or less per trade?]

Rkmacdonald shared some links to insightful articles on ETFs and their tax issues, including some excerpts. Click over to the whole discussion to read more.

The bottom line is that ETFs are well worth investigating. For some investors (maybe you!), some ETFs are very handy, offering low fees, instant diversification, tax-efficiency, ease of use, and low minimum investment amounts. Buy a few Spiders (AMEX: SPY  ) (for around $120 each), and you'll instantly be invested in all 500 of the S&P 500 companies. If you want to invest in regional banks or software but don't know which firms to choose, you might opt for ETF-like HOLDRs. The Software HOLDR (AMEX: SWH  ) , for example, contains Microsoft (Nasdaq: MSFT  ) , Computer Associates (NYSE: CA  ) , and BMC Software (NYSE: BMC  ) within its tight focus. The Regional Bank HOLDR (AMEX: RKH  ) instantly plunks you into the likes of State Street (NYSE: STT  ) and SunTrust (NYSE: STI  ) .

Learn more in our ETF Center, such as how ETFs stack up against mutual funds, how to develop an investment strategy with ETFs, pitfalls to avoid, and how to avoid ETF imposters.

These articles may also be of interest:

And get some free ETF reports, too, if you'd like.

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LongtimeFoolcontributorSelena Maranjianowns shares of Microsoft. The Fool has an ironclad disclosure policy.


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