Tax structure of ETFs
Along with low fees, ETFs are a good addition to your portfolio because of their tax efficiency. Rather than individually investing in a basket of securities and getting taxed on each capital gain, by investing in ETFs, you only get taxed on the gains you earn from the ETF.
Even if you choose to hold your ETF forever, you can still earn capital gains at the end of the year if the fund manager decides to sell the underlying securities. This is calculated by taking the gains from the year and subtracting the losses - the difference is distributed to shareholders as capital gains. Since most ETFs track an index like the S&P 500 or the Nasdaq, a manager only sells underlying securities if there is a change in the index’s holdings, which rarely happens. As a result, there are fewer capital gains to report at tax time, especially compared to active funds which aim to beat an index.
Essentially, the more you trade, the more potential capital gains but the higher taxes you will have to pay. As a result, investing in passive ETFs and holding these investments for a long term provides you with the highest tax efficiency, unless you’re using an IRA account to trade.
The amount you will have to pay in taxes depends on the tax rate and how long you hold a security for. If you hold a security for longer than 1 year, you will be charged a lower tax rate versus holding a security for less than a year.
For institutional investors, shares of an ETF can be redeemed in exchange for a basket of securities held by the fund. As a result, the fund never has to sell shares of its underlying securities to generate cash and this avoids generating taxable gains since these events are not considered as “taxable.”