You hear it all the time: exchange-traded funds are more tax-efficient than traditional mutual funds - what you don't hear is the reason why. Smartmoney gives a good answer:
When investors decide to exit an ETF they can sell their shares in the open market. In some cases, the authorized participant will redeem large chunks of ETF shares directly with an ETF sponsor like WisdomTree, performing what's called an "in-kind" redemption. In essence, they reverse the initial purchase transaction. So WisdomTree would return that sampling of individual shares in its portfolio to the AP in exchange for the ETF shares. The twist: WisdomTree will generally return the shares with the lowest cost basis — the ones it paid the least for and, hence, the ones with the highest potential capital gains — in order to hold down its potential tax hit. The AP doesn't care because its tax basis will be based on the current share price. The IRS perceives the whole deal as two companies exchanging one type of share for another, so it's not considered a taxable event.
That transaction method helps insulate existing ETF shareholders from unexpected capital gains — a luxury mutual fund holders don't enjoy. Indeed, an investor who leaves a mutual fund can potentially trigger capitals gains in their wake, since a manager has to sell shares to pay them off. Meanwhile, an investor who leaves an ETF pays taxes on his own profits; the existing shareholders don't get whacked with any unexpected capital gains."
Of course, non of this matters if you own your funds in a tax deferred account like an IRA.
Why are ETFs More Tax Efficient Anyway?
You hear it all the time: exchange-traded funds are more tax-efficient than traditional mutual funds - what you don't hear is the reason why. Smartmoney gives a good answer:
When investors decide to exit an ETF they can sell their shares in the open market. In some cases, the authorized participant will redeem large chunks of ETF shares directly with an ETF sponsor like WisdomTree, performing what's called an "in-kind" redemption. In essence, they reverse the initial purchase transaction. So WisdomTree would return that sampling of individual shares in its portfolio to the AP in exchange for the ETF shares. The twist: WisdomTree will generally return the shares with the lowest cost basis — the ones it paid the least for and, hence, the ones with the highest potential capital gains — in order to hold down its potential tax hit. The AP doesn't care because its tax basis will be based on the current share price. The IRS perceives the whole deal as two companies exchanging one type of share for another, so it's not considered a taxable event.
That transaction method helps insulate existing ETF shareholders from unexpected capital gains — a luxury mutual fund holders don't enjoy. Indeed, an investor who leaves a mutual fund can potentially trigger capitals gains in their wake, since a manager has to sell shares to pay them off. Meanwhile, an investor who leaves an ETF pays taxes on his own profits; the existing shareholders don't get whacked with any unexpected capital gains."
Of course, non of this matters if you own your funds in a tax deferred account like an IRA.
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