switching money
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Mutual funds and ETFs (exchange-traded funds) are common investments for personal portfolios. ETFs, which are traded on exchanges like stocks, are generally considered more tax efficient than mutual funds. But not always. Is it worthwhile from a tax standpoint to move your money to ETFs from mutual funds? We asked Bruce Bell, an attorney at the Chicago office of Schoenberg Finkel Beederman Bell Glazer.
Larry Light: Does such a transfer make sense?
Bruce Bell: You need to consider what type of assets are being invested to determine whether mutual funds or ETFs are appropriate in each circumstance. Let’s discuss mutual funds first.
Mutual funds are one of the most common types of investments for individual investors. They are designed to invest in a variety of securities from stocks, bonds, commodities and other types of investments. Some mutual funds are specific in nature to a particular type of investment. Some examples are large growth-oriented stocks and long-term bonds; other mutual funds are more general in nature. Money market funds which primarily invest in government notes and bonds and certificates of deposit are another type of mutual fund.
Falling into a category of regulated investment companies, mutual funds are generally not subject to federal income tax provided they annually distribute substantially all of their earnings including interest, dividends and capital gains to the mutual fund investors.
Light: How are they taxed?
Bell: Owners report mutual fund income the same way they report other income. That holds true for dividends, capital gains and other types of fund-distributed earnings. Some mutual funds are more tax efficient than others.
A mutual fund primarily invested in securities that generate a large amount of income that is taxable at the highest marginal federal income tax rate is less tax efficient than a one primarily invested in growth-oriented stocks, which generally produce a lesser amount of highly taxed earnings. Similarly, a mutual fund that does not purchase and sell securities on a frequent basis is likely to be more tax efficient than one that is a more active buyer and seller and routinely sells appreciated positions and generates capital gain income.
Light: And ETFs?
Bell: ETFs are similar to mutual funds in that they hold a portfolio of investments for their investors. Like mutual funds, ETF investors are taxed on fund distributions of interest, dividends, capital gains and the like. The major tax difference is that ETFs typically generate fewer capital gains, which are taxable to investors. One reason is that many ETFs are index based, meaning they are designed to track a market index such as the Standard and Poor’s 500 index. So they tend to be passively managed portfolios with lesser turnover of investments than mutual funds, many of which are actively managed and engage in more frequent purchases and sales of portfolio securities.
Light: So when should an investor opt for an ETF over a mutual fund?
Bell: While ETFs are generally more efficient from a tax perspective, an investor should consider which assets are being invested before focusing on tax efficiency. Clearly if the investment is made with assets held in an investor’s name individually, the tax efficiency makes ETFs a better tax-wise investment choice as the ETF investor will not be recognizing as much income as a mutual fund investor.
However, if the investment is made with assets held in a 401(k) plan, profit sharing plan, an IRA or some other tax deferred vehicle, the tax efficiency is far less meaningful as income from these accounts is tax deferred and tax will not be due and payable until distributions are made from the investor’s tax deferred account. As with mutual fund investments, a tax liability may arise upon the sale of ETF shares.
Light: But taxes aren’t everything, right?
Bell: As an investor, you should recognize that the most important consideration for any investment is not tax efficiency but the quality of the investment itself. Historical investment performance, projected future performance, expertise of the fund managers, investment and administrative charges and a multitude of other factors should be the primary determinants of whether and where to invest. Only after considering the available alternatives should income taxes be considered.
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