ETFs to Help Beat the Taxman

Jeremy Glaser: ETFs to beat the taxman. I'm Jeremy Glaser with Morningstar.com. I'm here today with director of ETF research Scott Burns to talk about some ETFs that can help keep your portfolio tax efficient.

Scott, thanks for joining me today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So in general, ETFs, tax-efficient investments?

Burns: First of all, when you asked me to talk about ETFs that help beat the taxman, the first answer is that ETFs themselves are inherently more tax efficient than most other fund vehicle structures.

That has to do with the creation-redemption mechanism that they have, so they're able to wash out a lot of the capital gains. So they don't eliminate your tax burden, but they do allow you to manage it.

For most ETFs, especially the vanilla ones, the only time you're going to make a cap gains kind of tax payment is when you actually choose to sell the ETF, not at the end of the year.

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Glaser: That's definitely true about stock funds. What about some of the more esoteric funds, like maybe a commodity ETN or something like that? Are those also tax efficient?

Burns: Right. Actually, it's actually a commodity ETF that's a little less tax efficient. That's subject to 60/40 taxation. If you want to invest in commodities and do so the most tax efficiently, you should look into using commodity-ETN-structured vehicles. Now of course that involves some credit risk, so you have to be comfortable with that.

But a sophisticated investor could actually do the cost-benefit analysis on what the tax liability difference is between the ETF or the ETN structure in a commodity, and think about doing things like buying deep out-of-the-money puts on the backing bank if they're really that concerned about the credit risk.

I'll tell you right now, for any investor that will almost always be in your favor to use the ETN.

Glaser: Now is there any problem with holding ETNs in a tax-advantaged account like an IRA?

Burns: That's the one thing. If you're in a tax-advantaged account with an ETN, there's really no reason to take on the credit risk, so you should just buy the ETF then.

You may have a little different tracking performance, ETN's a much purer tracking vehicle compared to the ETF, but you won't have the credit risk. You'll get very similar results.

So if the taxman's not in the picture, we generally prefer ETFs. If the taxman's in the picture, we generally prefer ETNs.

Glaser: What about bond funds?

Burns: ETFs are look-through vehicles, so a bond fund in and of itself, the IRS will look through the ETF and say, "You own bonds. We're going to tax you like bonds."

So the coupons will be ordinary income, and any cap gains inside the fund would be cap gains much like anything else. Of course they wash out a lot of those, so if you buy and hold it and sell it after two years, it'll be long-term cap gains.

Of course there are municipal bond ETFs, and they're very popular. They've been growing quite a bit. You can use those funds to, depending on your tax bracket, lower your ordinary income, just like you would owning individual municipal bonds, but you'll have the benefit of higher liquidity and more diversification.

There's another bond ETF out there that offers a very unique advantage, and those are the TIPS bonds funds, the Treasury Inflation-Protected Security funds. If you owned an individual TIP fund, or TIP bond, I should say, at the end of the year they're going to make the adjustment for CPI.

Assuming that we're in a mildly inflationary environment, what's going to happen is even though you won't receive cash for that adjustment, because they just adjust the coupon, not the principal, you're going to receive an income tax bill for that adjustment as if it was real income. So you'll get a tax bill and no cash. That's really what people hate the most is paying taxes on things they didn't have cash for.

The TIPS ETFs have a very unique mechanism where they actually sell bonds inside the fund. So you don't avoid having to pay the tax, but you do have cash with which to pay it.

Glaser: Great, Scott. Some excellent tips to keep that tax bill down.

Burns: Thank you.

Glaser: From Morningstar.com, I'm Jeremy Glaser.