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By Jeremy Glaser | 03-11-2011 03:55 PM

Must-Know Facts About ETFs and Taxes

Much of the oft-cited tax efficiency of an ETF actually depends on the fund's underlying holdings and strategy, as well as how it's used by investors, says Morningstar's director of North American ETF research Paul Justice.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

It's Tax Relief Week here at Morningstar.com. I'm here with Paul Justice. He is the director of North American ETF research. We're going to take a look at what ETFs make sense for taxable account and how they compared to some other investment products out there.

Paul, thanks for joining me today.

Paul Justice: Oh, my pleasure.

Glaser: So, I think that a lot of people know that ETFs are generally a pretty tax efficient vehicle, but are they dramatically more tax efficient than some other investments that people might be considering, like a traditional mutual fund index fund?

Justice: Well, it's interesting you bring that up. For the most part, ETFs are going to be index mutual funds. The F in ETF is still fund, and most of them are going to be the passive sort of index, at least where all the money is right now, that's where you're going to find it. And that's where most of the tax efficiency of ETFs come from. The passive nature of the fund itself--the index.

Now, if you compare an index ETF, say the S&P 500 versus an S&P 500 mutual fund, there is a good chance you're going to get a slight improvement on the tax efficiency of the ETF, so long as you're performing good behavior on the behalf of the investor yourself. It's very similar to the argument, the NRA makes about guns. Guns don't kill people, people kill people. If you're going to day trade an ETF in your taxable account, you're going to hit with a lot of taxes, but that's going to be a user problem not a fund problem. If you're going to hold on to it for a very period of time, ETFs can be a very low cost, tax-efficient manner if you wish to get that exposure.

Glaser: So, if I have a portfolio of index mutual funds right now, does it make a lot of sense to sell all of those and replace them with their ETF equivalents just for that tax advantage?

Justice: No, if you're going to go through that trouble--chances are, let's say, you've held those funds for a long period of time. Most index investors are buy-and-hold types, either you're going to sell those or you're going to generate that taxable gain. It's going to wipe out the minuscule difference that you're going to get from going to the ETF structure.

Now, on the flipside, if you do have some losses built up there, that could be a good tax-loss harvesting strategy to sell out some of those Index mutual funds, realize the loss and allocate it to a similar but different strategy, say switching from an MSCI Index to a Russell Index or vice-versa. Dow Jones and S&P would count towards that too--to give you similar exposure, but to reap those losses and get your exposure set back with a cost basis that's neutral.

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