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Exchange-traded funds are extremely popular with investors, both for their low fees and their favorable tax treatment due to the way they are classified by the IRS. In a nutshell, capital gains taxes are triggered in a mutual fund whenever assets are sold within the fund, but with ETFs, gains are generally only realized and taxed when the investor sells shares in the fund.Taxation in a mutual fund, whether it’s a traditional fund or an ETF, is based on the appreciation in value of the fund over time. When an investor realizes a profit, or capital gain, it triggers a tax payment. In a mutual fund, profit is generated when the fund manager sells off equities within the fund, which is then passed on to the investor. With an ETF, profit (or loss) is realized when the investor redeems shares. Of course, these tax events only apply to individual, taxable accounts, and not tax-deferred accounts such as IRAs and 401(k) plans.Structural differences in the way mutual funds and ETFs are organized account for the difference in tax treatment. Mutual fund transactions are always with the fund sponsor; shares are bought from and sold to the institution offering the fund. ETFs on the other hand are traded between individual investors on the stock exchange.This is an important difference, because it means that whenever a mutual fund has a lot of redemptions, it has to sell off assets to raise cash to pay out the investors. These transactions create capital gains, triggering a tax liability. Mutual funds also have transactions during periodic rebalancing, creating even more capital gains exposure.ETFs have far fewer transactions that may trigger capital gains. In fact, turnover in an ETF is extremely low, and securities are only sold when one is dropped from the index. This virtually eliminates the capital gains produced in a mutual fund.For example, the average mutual fund in the emerging markets space pays about 6.5% of NAV to shareholders in the form of capital gains each year, while ETFs tracking the same indices pay out just 0.01% in capital gains. In the 10-year period ending in 2010, mutual funds In the small-cap market produced capital gains of about 7% of NAV, while small-cap ETFs produced about 0.02% of NAV in taxable gains.Perhaps the worst thing about capital gains taxes in mutual funds is that shareholders owe them on profitable transactions within the fund, even if the fund overall shows a loss for the year. The fund’s loss of value doesn’t offset capital gains generated by selling assets within the fund.Investors tend to discount or minimize the effect of capital gains taxes on the overall performance of a fund, but over time, the capital gains tax bite can be significant. A $100,000 investment averaging 4% returns each year and 1% capital gains taxes will lose $1,000 the first year, and almost $6,000 over five years.Taxes on dividends in ETFs are treated a bit differently. The rules regarding qualified dividends are complex. Basically, the investor must own the stock in the fund paying the dividend for at least 60 days of the 121-day period surrounding the ex-dividend date, and the dividend must be paid by a qualified corporation in order to count as a qualified dividend for tax purposes.Qualified dividends are taxed at between 5% and 15%, depending on the investor’s income tax bracket. Unqualified dividends are taxed at the investor’s normal income tax rate. Dividend tax treatment is the same for mutual funds and ETFs, and the taxes apply whether the dividends are paid out to the investor or reinvested into the fund.ETFs beat mutual funds in the tax department in two major ways: They generate fewer taxable capital gains due to transactions within the fund, and the gains on shares within the fund aren’t taxed until they’re sold, which gives investors far more control over their tax liability in any given year.
There’s a definite case to be made that exchange-traded funds, or ETFs, are extraordinarily cheap to own. For just $3 per $10,000 invested, you can own a piece of the top 3,500 large-, medium-, and small-cap companies in the U.S. with the iShares Core S&P Total U.S. Stock Market ETF (ITOT). In fact, there are currently over 30 ETFs with expense ratios of 0.05% ($5 per $10,000 invested) or less on the U.S. market.Before ETFs hit the market in 1993, such low expense ratios were unheard of in the mutual fund world, where fees of 2%, 3% or more weren’t uncommon. They’ve become incredibly popular since their introduction, and their low fees are exerting downward pressure on other types of mutual funds. It’s now possible to find traditional mutual funds and index funds with expense ratios well below 1%.But expense ratios are just part of the overall expense involved in trading and holding a fund. Because ETFs are traded on the exchange like a regular stock, you will always pay a commission when you buy or sell them. It is possible, however, to buy and sell certain index funds without a transaction fee.If you’re buying shares on a regular basis, your ETF trading costs could wipe out your gains, and you may be better off with a zero-transaction cost index fund. If you’re making one large purchase and plan to hold your shares for a long time, ETFs may well be cheaper.Because of their unique structure, ETFs tend to be far more tax efficient than index funds and other traditional mutual funds. Index and mutual fund managers need to make more frequent transactions to rebalance their portfolios, exposing you to capital gains taxes. ETFs mostly avoid these internal trades, reducing your potential for capital gains.There’s also the issue of bid-ask spread with ETFs. That can be significant in funds with low volume and poor liquidity. Index and mutual funds aren’t subject to spread, since they are priced once a day after the market closes. However, you can mitigate the effects of spread with ETFs by placing limit and stop orders.Dividends are another area that affect the overall cost of an ETF compared to an index fund. Index funds typically offer fee-free automatic dividend reinvestment, which means dividends are reinvested as soon as they are paid out—and index funds allow you to purchase fractional shares based on a fixed dollar amount.Some, although certainly not all, ETFs offer a dividend reinvestment program, but investors have to wait for the dividend funds to settle in their brokerage account before using them to purchase additional shares. These trades are not commission-free, and you can only buy whole shares in an ETF.There are behavioral issues which may also affect costs associated with ETFs. For example, index funds allow you to invest set dollar amounts each month; you can buy partial shares. ETFs require you to buy the entire share, so if you are allocating a set dollar amount to your investment account each month, you will always have some money left over as uninvested cash. Again, if you are paying commissions each month on your ETF trades, they will undoubtedly cost you more than buying commission-free index funds.The other behavioral risk is tied to the exchange-traded nature of ETFs. There is a temptation to trade more often in an attempt to “time” the market, which generally leads to more frequent trades, and higher overall commission charges.It’s really impossible to say whether or not ETFs will be the cheapest way for you to invest. It depends on your investment philosophy, trading patterns, and long-term investment goals.