Longtime investors in mutual funds know that you have to be careful when you buy new mutual fund shares in taxable accounts. As the end of the year approaches, many mutual funds make distributions of income and capital gains that have accumulated during the year. These distributions, which can be very large, represent taxable income to shareholders, regardless of when you actually purchased the fund. So even if you didn't yet own the fund and therefore didn't benefit, you will still be left holding the tax bill if you do own the fund when it makes its year-end distributions. The lesson that mutual fund investors have learned -- in some cases, the hard way -- is to avoid buying new shares immediately before those year-end distributions.
When exchange-traded funds started becoming popular, proponents said they would solve the problem of big year-end mutual fund distributions. However, some ETFs do carry tax issues of their own. While some of these problems affect other types of investments, ETF investors may find them particularly surprising, especially if their primary motivation for using ETFs was to maximize control of their taxes.
The problem with mutual funds
The legal requirement that mutual funds pass their income and realized capital gains to their investors is one of the least attractive aspects of mutual fund ownership, since the payouts can have a big impact on your taxes. For instance, earlier this year, the popular mutual fund Fidelity Magellan (FUND: FMAGX ) paid a capital gains distribution of more than $22 per share -- nearly 20% of the fund's net asset value -- to its investors. Anyone who reinvested the distribution into additional shares saw no impact on the value of their shares, but they will nevertheless have to report the distribution as taxable capital gains on their 2006 income tax returns.
The perfect solution?
Unlike actively managed mutual funds, ETFs generally don't have to worry about new investors buying fund shares or existing investors selling them. With ETFs, most trades occur in the secondary market and do not involve the fund itself at all. Although most ETFs have mechanisms that allow financial institutions and other large shareholders to make share transactions in large blocks directly with the fund, most of these mechanisms give the fund the option of using the stocks in which the fund has invested as payment in kind for fund shares. Because the ETF never actually sells its stocks, it never generates a capital gain that must be distributed to the fund's investors. In contrast, because traditional mutual funds must always be prepared to pay cash when an investor decides to sell, they often have to sell fund assets if shareholders choose to withdraw significant amounts of money from the fund.
ETFs therefore give shareholders greater control over when they want to realize and pay taxes on capital gains. In the absence of forced fund distributions, shareholders can generally postpone tax liability indefinitely simply by not selling shares. Although ETF dividend payments will still create some tax liability, the larger problem of capital gains distributions is effectively eliminated.
But as we mentioned, ETFs don't eliminate tax issues altogether.
Qualified dividends and ETFs
In 2003, a new law reduced tax rates on certain transactions, including a new 15% maximum tax rate on long-term capital gains and qualified dividends. In general, dividends are considered qualified if they were paid by domestic corporations or certain foreign corporations that either traded on U.S. stock markets or were organized in possessions of the United States.
This meant that depending on a particular mutual fund's holdings, all, part, or none of its dividend distributions might count as being qualified. The income dividends of fixed-income mutual funds, for instance, included no qualified dividend income. But for some domestic stock funds, all distributions might be considered qualified. With regular tax rates of up to 35% applying to non-qualified dividends, investors had a lot at stake.
One problem with some ETFs comes from an intricacy of the tax law. Even if a dividend comes from a domestic company, the owner of the stock must hold that stock for a certain period of time around the dividend date. This rule discourages traders from buying a stock immediately before a dividend is paid, getting income at a low tax rate, and then immediately selling the stock again. However, this rule can also capture ETFs that make in-kind distributions of their assets or that lend out securities to other institutions before meeting the minimum holding period requirement. As a result, even an ETF that invests solely in qualifying stocks might not have 100% of its dividends count as qualified.
Of course, for many taxpayers, this is a relatively minor issue. Paying extra tax on a few percentage points of income may not be significant if you're talking about only a few hundred dollars in distributions. It is, however, a good reminder of the things you have to worry about with assets in your taxable accounts.
Other ETF tax issues
In addition to qualified dividends, some other aspects of the tax law can trap ETF investors. In general, ETF investors must look through to the ETF's assets for guidance on how income and capital gains will be taxed. For instance, the IRS classifies investments in certain commodities, such as gold and silver bullion, as collectibles. This makes them ineligible for the 15% capital gains rate and imposes a higher rate of 28% on any gains. Although shareholders in precious-metal ETFs, such as StreetTracks Gold Shares (NYSE: GLD ) and iShares Silver Trust (NYSE: SLV ) , may buy and sell their shares as they would with any other stock, the ETFs themselves own physical gold and silver. Therefore, when it comes to calculating capital gains, investors have to treat gains as coming from the sale of collectibles and pay the higher rate of tax. Similarly, investors in ETFs that use futures as investments, including some of the new commodities-based ETFs that have recently become popular, must treat their profits in a manner consistent with how the IRS taxes futures contracts.
Many investments claim to have tax advantages over others. Before concluding that an investment is tax-efficient, however, you have to consider all of the possible tax provisions that can apply to its income or price appreciation.
Want to know more about exchange-traded funds? Check out the Fool's ETF Center to find lots of information for everyone from beginners to experienced investors. It's just a part of what the Fool does to educate, amuse, and enrich its readers.
Fool contributor Dan Caplinger always tries to minimize his tax bill, although he still prefers profits to losses. He doesn't own shares of any of the companies or funds mentioned in this article. The Fool's disclosure policy is never taxing.