Everywhere you read, people seem to be discussing the benefits of ETFs. Discussion usually centers on how passive funds perform better overtime than actively managed mutual funds. One reason for this is that the odds of consecutively beating the market diminishes over time, and becomes no greater than chance. Aiming for average market returns, as ETFs do, helps portfolio growth and compounding of investments while minimizing risk. The other reason is that expense ratios of managing ETFs are much lower than most other investment vehicles. And it turns out, the expense ratio is often considered to be the best predictor of a funds performance.
While these are the main reasons people purchase ETFs, they also factor into why ETFs can help you save on taxes—compared to many active mutual funds. ETFs are cheaper to manage because they track an index, instead of paying higher fees to have your fund actively traded. As they focus on average market returns, instead of beating the market, ETFs make fewer transactions. Because ETFs are buying and selling less, the transaction costs and capital gains taxed are minimized. Most Mutual funds, on the other hand, are trading much more often, and incur more transaction costs that potentially tax each trade. The higher taxed mutual fund means less money to invest overall. As a result, ETFs save you money by trading and charging you less, while investing more of your money.
Another important tax feature of ETFs is that capital gains are taxed when you buy and sell the fund. Most Active mutual funds, on the other hand, are taxed every year in which a gain is distributed. By delaying the tax on a gain, you reinvest it back into the fund, allowing more of your money to be invested and accumulate over time. This tax friendliness ensures you grow your wealth more quickly and efficiently.
Lastly, how you are taxed on ETFs differs by the duration of time you hold them. A “wash-sale” rule restricts the sale of an ETF at a loss for tax purposes, if the same ETF is repurchased within 30 days. This deters people who don’t want to be left outside a particular market for a month.