What is the ETF tax loophole?
Key Takeaways. ETFs allow investors to circumvent a tax rule found among mutual fund transactions related to capital gains. ETFs are structured in a way that avoids taxable events for ETF shareholders.
Most investors hold their mutual funds in accounts at brokerage firms (whether tax-deferred retirement accounts or taxable accounts) or in 401(k) retirement plans. In these cases, investors don't have to pay extra taxes when a mutual fund they own converts to an ETF.
Special treatment for certain ETF losses
Currency ETFs do not generate capital gains or losses, but rather ordinary income or losses. This means that losses on the sale of shares in these ETFs produce ordinary losses that can be used to offset ordinary income, such as wages and bank interest.
ETFs benefit from creation/redemption process
ETFs are insulated from engaging in these types of cash transactions, which is the key to their tax efficiency.
However, there are disadvantages of ETFs. They come with fees, can stray from the value of their underlying asset, and (like any investment) come with risks.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
If you own a stock where the company has declared bankruptcy and the stock has become worthless, you can generally deduct the full amount of your loss on that stock — up to annual IRS limits with the ability to carry excess losses forward to future years.
To avoid a wash sale, you could replace it with a different ETF (or several different ETFs) with similar but not identical assets, such as one tracking the Russell 1000® Index.
These gains are taxable for all fund shareholders. By contrast, ETF managers accommodate investment inflows and outflows through the in-kind share creation and redemption process, which enables them to shed securities that may generate significant capital gains.
Which ETFs are tax free?
- Vanguard Tax-Exempt Bond ETF (VTEB)
- Vanguard Short-Term Tax-Exempt Bond ETF (VTES)
- Vanguard High-Yield Tax-Exempt Fund Investor Shares (VWAHX)
- Schwab Tax-Free Bond Fund (SWNTX)
- Fidelity Municipal Bond Index Fund (FMBIX)
- Dimensional National Municipal Bond ETF (DFNM)
- iShares Short-Term National Muni Bond ETF (SUB)
With some exceptions for certain types of ETFs, long-term capital gains are taxed at no more than 15% (zero for investors in the 10% or 15% tax bracket; 20% for investors in the 39.6% tax bracket ).
Treatment of gain or loss realized on selling the ETFs: While return of capital is a form of distribution, they are considered a non-taxable event that will impact an investor's book value and therefore affect the calculation of capital gains and losses of the investor when units are sold.
In fact, 47% of all such funds have closed down, compared with a closure rate of 28% for nonleveraged, noninverse ETFs. "Leveraged and inverse funds generally aren't meant to be held for longer than a day, and some types of leveraged and inverse ETFs tend to lose the majority of their value over time," Emily says.
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.
Gains from selling currency ETFs structured as grantor trusts are always treated as ordinary income (currently up to the 40.8% rate) while those structured as limited partnerships are taxed using the 60/40 rule.
Holding period:
If you hold ETF shares for one year or less, then gain is short-term capital gain. If you hold ETF shares for more than one year, then gain is long-term capital gain.
- iShares Core S&P 500 ETF IVV.
- iShares Core S&P Total U.S. Stock Market ETF ITOT.
- Schwab U.S. Broad Market ETF SCHB.
- Vanguard S&P 500 ETF VOO.
- Vanguard Total Stock Market ETF VTI.
| ETF | Assets under management | Expense ratio |
|---|---|---|
| Invesco QQQ Trust (ticker: QQQ) | $244 billion | 0.2% |
| VanEck Semiconductor ETF (SMH) | $14 billion | 0.35% |
| Consumer Discretionary Select Sector SPDR Fund (XLY) | $19 billion | 0.09% |
| Global X Uranium ETF (URA) | $3 billion | 0.69% |
Why would anyone buy mutual funds over ETFs?
Mutual funds offer automatic investment plans and ETFs do not. These services facilitate regular contributions and allow investors a consistent way to grow their investments, especially for retirement.
So when is the ideal time? "Middle of the day is generally best, and if there are international (European) securities in the ETF, trading in the morning will ensure you get prices closest to fair value," Nadig explains.
You can deduct capital losses up to the amount of your capital gains plus $3,000 ($1,500 if married filing separately). You may be able to use capital losses that exceed this limit in future years.
The $3,000 loss limit is the amount that can go against ordinary income. Above $3,000 is where things can get a little complicated. The $3,000 loss limit rule can be found in IRC Section 1211(b). For investors who have more than $3,000 in capital losses, the remaining amount can't be used toward the current tax year.
If you own securities, including stocks, and they become totally worthless, you have a capital loss but not a deduction for bad debt. Worthless securities also include securities that you abandon.
