Have you ever made what seemed to be a fairly simple investment, but then you received K-1s or other complex information you didn’t expect at tax time? Worse yet, maybe the tax information arrived after you already filed your return and you had to amend. K-1s in particular are known for causing delays and additional costs in tax preparation.
You may not even realize what the investment you are considering entails. Ask if it is an ETF (exchange traded fund), and make sure that you understand the nature, underlying assets, and tax consequences of whatever you are considering. Well-established ETFs are likely to be less troublesome.
Some newer ETFs are organized as partnerships or trusts, requiring sponsors to provide K-1s. Other ETFs may be totally different animals in terms of taxation because of exposure to foreign currencies, metals, and other holdings. An ETF that holds gold, for example, would generate gains subject to the higher federal tax rate on collectibles (28% instead of 15%). ETFs can hold futures-based funds, which are look-through vehicles for tax purposes. Futures contracts with a mark-to-market methodology can require recognition of gain even if you sell nothing, making paper profits taxable.
ETFs can have excellent investment features and benefits
ETFs or exchange traded funds are relatively new investment structures built around characteristics of both mutual funds and stocks. Financial institutions purchase and redeem ETF “creation units” (shares), which can trade at a discount or premium of net asset value directly from ETF providers.
While generally providing easy diversification, low expense ratios, and tax efficiency, ETFs maintain all the features of ordinary stock such as limit orders, short selling, and options.
Transparency is another advantage of ETFs, whether they are index funds or are actively managed. Although ETFs typically have lower average expense ratios than comparable mutual funds, they pay commission charges on each purchase or sale. No-load mutual funds, on the other hand, impose no commissions when purchased through various venues, including direct transactions with the fund.
The popularity of ETFs is rapidly increasing
The first ETFs started in the U.S. in 1993 and functioned initially like index funds. But in 2008, the U.S. Securities and Exchange Commission began to authorize the creation of actively managed ETFs. The industry has experienced rapid growth, and today there are about 1,000 ETFs with estimated assets of more than $790 billion.
Traditional ETFs have several tax advantages
Unlike mutual funds, ETF sponsors typically assign specific securities to each fund and generally do not experience cash flows into or out of the fund. This can be an advantage over mutual funds, which are required to periodically distribute capital gains to all investors in proportion to their ownership, regardless of the length of their investment in the fund. With well-established ETFs, investors have generally been able to pay very little capital gains tax until they sell their interest. However, in recent years certain funds from top ETF firms have been realizing more substantial trading profits, which they are required to pass through as taxable capital gains. This is more likely for newer ETFs (launched after 2005).
Be aware of possible problems, but don’t rule out ETFs
Initially inspired by broad-based stock market indices, ETFs have evolved into bond offerings, commodities, and specialized indices. Institutional investors keep increasing, and some ETFs are now sophisticated trading and hedging strategies.
Although nearly 1,000 ETFs are traded daily, recently more than 100 have closed. Most of the failed ones were start-up funds attempting to invest in a very narrow space in the market. Investors may be wise to stick with established ETFs. The three largest providers of ETFs are BlackRock Inc. (who in December 2009 completed acquisition of Barclays iShare products), State Street Corp., and Vanguard Group. As of June 30, 2010, these three companies had about 83% of all ETF assets.
Aside from recent glitches with some of the newer ETFs with thinly traded securities and hidden tax traps where the structure does not work smoothly, the wide variety of traditional ETF offerings based on index strategies continues to offer appeal to investors for ease of diversification, low costs, potential for tax efficiency, and trading ability.