How Much Value Does an ETF Add to My Taxable Account?
VICE PRESIDENT, RELATIONSHIP DIRECTOR & INVESTMENT SPECIALISTJeff Cornell
VICE PRESIDENT, RELATIONSHIP DIRECTOR & INVESTMENT SPECIALIST
Financial advisors weigh many complex considerations to help clients achieve their goals, including the tax consequences of different investment vehicles. According to the 2019 Trends in Investing Survey, 88% of advisors use or recommend exchange-traded funds (ETFs), up from 40% in 2006 when the survey began. Advisors have preferred ETFs over mutual funds for the last four years.1 As of January 2020, there was $4.42 trillion invested across 2,100 U.S.-based ETFs.2
So why are so many advisors moving their clients’ money into these products? One big reason is the advantage an ETF may have over a traditional mutual fund in a taxable account. ETF investors may pay less in taxes today, leaving a larger sum to invest and grow into the future.
In a mutual fund, income received from dividends and realized capital gains inside the fund are distributed to the investor each year—on which she must then pay taxes to the IRS and her state of residency, as applicable. Like a mutual fund, an ETF is required to distribute income received from dividends. However, the in-kind transaction structure of an ETF can minimize capital gains realizations inside the ETF.3 As a result, an ETF investor is expected to receive lower distributions compared to a mutual fund and therefore a lower annual tax bill. Year over year, money that could have been paid in capital gains taxes on a mutual fund investment would instead compound for the ETF investor, potentially resulting in greater total gains—maybe even accounting for the tax bill on the final gains at liquidation.
In this paper, we share some hypothetical examples to show the magnitude of the impact and expected advantage an ETF has over a mutual fund in a taxable account. For readers interested in understanding more about the design differences between ETFs and mutual funds, we suggest “ETFs – An Important Tool for Wealth Management” by our Avantis colleagues Phil McInnis and Mitch Firestein.
1 Trends in Investing Survey is conducted by the Journal of Financial Planning and the FPA Research and Practice Institute™, 2014, 2018 and 2019 reports, Financial Planning Association, www.onefpa.org
2 “ETF Assets and Net Issuance, January 2020,” Investment Company Institute (ICI), February 27, 2020.
3 Phil McInnis and Mitchell Firestein, “ETFs – An Important Tool for Wealth Management,” Avantis Investors, October 2019, www.avantisinvestors.com/content/avantis/en/insights/etfs-important-tool-for-wealth-management.html
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
The information in this document does not represent a recommendation to buy, sell or hold security. The trading techniques offered in this report do not guarantee best execution or pricing.
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