Taxes are an important consideration for any investment held in a taxable account. In general, passive ETFs are considered tax-efficient on an absolute basis due to their unique structure, generally lower portfolio turnover, and how they are managed. One of the primary advantages of the ETF structure is that when an investor buys or sells shares of the ETF, the ETF administrator can match purchases and sales with other investors so that no actual security purchases inside the fund need to be made. As a result, this creation/redemption structure avoids triggering a taxable event.
With that said, not all ETFs are equally tax-efficient.
For example, ETF dividends are subject to taxes, and ETFs that pay nonqualified dividends may be less tax-efficient than those that pay qualified dividends. Annual distributions from an ETF to investors may be treated as qualified or nonqualified dividends. Qualified dividends are taxed at no more than 15%. However, just because the ETF reports that its distribution was a qualified dividend, that does not automatically make it qualified for the investor. The investor must have held the ETF for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. ETF investors, like mutual fund investors, are subject to the relevant tax rates on distributions that flow through to end investors, whether they take the form of dividends on stocks or coupon payments on bonds.
It's also possible to invest tax-efficiently with ETFs by selecting those that minimize capital gains distributions and maximize exposure to qualified dividends, as well as holding tax-inefficient ETFs in tax-deferred or tax-exempt accounts. If minimizing taxes is a concern, consider consulting a qualified tax advisor.
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