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.
Jeremy Glaser: So in general, ETFs, tax-efficient investments?
Scott 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.
Jeremy 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?
Scott 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.
Jeremy Glaser: Now is there any problem with holding ETNs in a tax-advantaged
account like an IRA?
Scott 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.
Jeremy Glaser: What about bond funds?
Scott 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.
Jeremy Glaser: Great, Scott. Some excellent tips to keep that tax bill down.
Scott Burns: Thank you.
Jeremy Glaser: From Morningstar.com, I'm Jeremy Glaser.