While ETFs are generally regarded as “tax-efficient” investments, the multiplicity of product structures in the ETP market has created a maze of confusing possible outcomes. But by choosing the right ETP structure, along with placing it in the right type of account, advisors can help clients to greatly reduce clients’ tax bill.
ETP asset classes include bonds, commodities, currencies and stocks. Some ETPs will own the underlying securities while others will use derivatives like options or futures contracts to obtain their exposure.
Regarding product structures, ETPs generally use the following types: open-end funds, unit investment trusts (UITs), grantor trusts, limited partnerships (LPs) and exchange-traded notes (ETNs).
Before examining the specific tax treatment of ETPs, let’s analyze some simple tax-cutting strategies that use the instruments.
Smart Asset Location
Diligent financial advisors are wise to spend effort in determining the correct asset allocation for clients. But they should not overlook the importance of smart “asset location.” It’s a deliberate process that involves strategically located ETP investments among taxable and tax-deferred accounts to cut tax liabilities.
Since most equity ETFs are tax-efficient, they are an ideal choice in taxable brokerage accounts. The funds have low portfolio turnover and the redemption/creation mechanism within the fund allows portfolio managers to pass capital gains to institutional investors that redeem creation units, thereby eliminating capital gains distributions at the end of the year for ETF shareholders.
Although there are different schools of thought when it comes to asset allocation, it’s generally wise to hold bonds and REITs inside tax-deferred accounts like 401(k) plans and IRAs. Because the majority of the return delivered from bonds and REITs is via income or dividend payment, they’re subjected to potentially less favorable ordinary income tax rates. Smart “asset location” eliminates the burden of paying annual income taxes on bond interest and REIT dividends.
Tax-loss harvesting with ETFs is another opportunity to further reduce taxes. The strategy involves selling unprofitable investments and using the losses to offset taxable gains from investment winners. Keep in mind the IRS’s wash sale rule, which disallows tax losses if you sell an investment and buy something “substantially identical” within a 30 day period. Fortunately, the number of ETF choices has given advisors and their clients plenty of opportunities to maximize their tax savings. Here’s an example of tax-loss selling: Suppose a client bought $50,000 worth of Chevron in a taxable account and the value of the investment has fallen to $48,000. By selling Chevron and replacing it with the Select Sector Energy SPDR (XLE), the client would realize a $2,000 tax loss but still keep market exposure to energy stocks. That $2,000 loss can be used to offset capital gains in other investments or to offset up to $3,000 in ordinary income taxes.
Bear in Mind
This guide explains the general tax consequences for ETP products held within taxable investment accounts. The tax rates cited are applicable to the 2012 tax year and are subject to change. Please be aware that every investor’s tax situation is unique and a tax professional should always be consulted. This educational tool should not be construed as tax advice.