In February, market results were mixed. International stocks and bonds increased, while US large and small-cap stocks fell. So far for the year, US small-cap stocks are down, while large-cap, bonds, and international stocks had positive returns.
ETFs – The Ability to Defer and Control Taxes
While the filing deadline isn’t until April 15th, the month of March is the apex of tax season. Last week, Charles Schwab released the final round of 1099 Composite tax forms. For many taxpayers, this could be the last piece of information needed to file; many people have been anxiously awaiting their arrival.
While a W2 form shows the amount of money an employee earned at work, a 1099 Composite shows the amount of income an investment account earned. Usually this consists of three parts – interest, dividends, and capital gains. As investors, we want to earn as much as possible and pay tax on as little as possible (legally, of course). Interest and dividends have very little tax flexibility – usually they are taxable in the year they are paid. But regarding capital gains, Exchange-Traded Funds (ETFs) can provide a significant benefit compared to mutual funds. In many cases, they can completely avoid annual capital gain payouts.
One of the main reasons is that ETFs trade on an exchange like a stock, while mutual fund companies create and redeem shares of their funds. If you want to sell an ETF, you can trade it directly to another investor. If you want to sell a mutual fund, you sell it back to the fund company. And if a large number of investors want to sell, the mutual fund must sell its underlying investments, which creates capital gains. And these gains get distributed to all fund shareholders, even those who didn’t transact at all.
In some cases, these payouts can be huge. According to Morningstar, here are the five biggest capital gain distribution estimates by mutual fund for 2024:
An unlucky investor with a $100,000 investment in one of these funds could be on the hook for a tax bill in the tens of thousands of dollars. Meanwhile, the vast majority of ETFs pay zero capital gains. And if they do pay out a capital gain distribution, it tends to be only a small fraction of the fund’s value.
The benefit to ETF investors? Increased control. If you don’t need to sell and realize gains, they are deferred into the future. If you are charitably inclined, appreciated ETFs can be donated directly to charity, which avoids capital gains tax. Additionally, in many cases ETFs are eligible for a step-up in cost basis when an investor passes away. This means that if you defer gains long enough, the beneficiaries of these assets won’t owe any tax on their inheritance.
Having more control over when you pay capital gains taxes make investing in ETFs quite attractive in a taxable account. If you would like to discuss this topic in more detail, please let us know.
