ETFs and Taxes: Everything You Need to Know

by: SA Editors

The panel is sponsored by Invesco PowerShares.


Two Types of Investment Decisions

As with most things in life, being a successful investor involves the ability to manipulate a combination of 'knowns' and 'unknowns'. 'Will the market go up or down?' is something we can't possibly know the answer to in advance. We can prognosticate and make our best educated guess but ultimately, the market's performance is out of our control.

What tax rate we pay on our portfolios is something that fits into the realm of 'known' items. How well we understand the tax structure of the various investments we hold and whether or not we utilize money-saving techniques like tax loss harvesting are within our control as investors. Markets are cyclical; they go up and down. Given a long enough time horizon, most asset classes will revert to their means, having an equalizing effect on investors' long-term performance. Successfully manipulating that which is known as best as we can is often the difference between retiring comfortably, or seeing a combination of management costs and improperly managed tax liabilities eat away at what should be a steady long-term savings rate.

Tax Benefits of ETFs

One of the reasons for the continuing impressive growth of Exchange Traded Fund usage both among professional and retail investors is that the ETF structure is significantly more tax efficient than the mutual fund structure. As pooled investments, mutual funds routinely obligate investors that hold them in standard taxable brokerage accounts to pay taxes though they personally didn't choose to sell their shares. ETFs allow investors to individually determine when to face a 'taxable event' triggered by a sale. That said, there are complexities tied to ETFs and taxes - many of these not yet well understood by the average investor - as ETFs grant access to a range of asset classes investors didn't previously have access to.

On Wednesday, November 17, at 4 p.m. ET, Seeking Alpha hosted a live event to help investors better understand everything they need to know about ETFs and tax issues. Whether you are considering investing in ETFs for the first time or you are a seasoned ETF investor, this event likely had something to teach you.

Our two panelists for this event were John Hoffman of PowerShares and Jerry Slusiewicz of Pacific Financial Planners:

John Hoffman, PowerShares

John Hoffman is an Institutional Portfolio Consultant for Invesco PowerShares focusing on ETF sales and distribution throughout the U.S. He covers hedge funds, endowments, foundations and corporate accounts. In addition, Hoffman works with ETF trade desks, market makers, proprietary trading groups and other institutions that are instrumental in providing liquidity in the U.S. ETF market.

Jerry Slusiewicz, Pacific Financial Planners

Jerry Slusiewicz has over two decades of professional investment experience, most recently as Portfolio Manager for Pacific Financial Planners. He has worked with individuals and institutions to manage money for both short and long-term investment horizons. This extensive experience through various stock and bond market cycles enables him to offer a unique blend of professional investment counsel and personal service.

What follows is an edited transcript of the event broken down by topic so you can more easily locate themes that interest you.

~ Jonathan Liss, Senior Editor for ETF Content

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Live-chat intro: ETFs and the tax man

Jonathan Liss, SA Editor: With U.S.-based ETF assets just below $950 billion and ETFs generally atop the daily 'most traded' securities list, ETFs have become part-and-parcel of the American financial landscape. 'Typical ETF investors' have likewise evolved to include retail investors and smaller-scale financial professionals, in addition to the institutional investors that were instrumental in initially creating robust demand for exchange traded funds. In the latest piece of news demonstrating the new-found wider adoption of ETFs across the investing landscape, last week Charles Schwab (NYSE:SCHW) reported that its brokerage client accounts now held more than $100 billion worth of ETF assets in total - only about 2% of which was comprised of Schwab's own line of ETFs.

The growth in the number of investors, both large and small, using exchange traded products has meant an increased necessity to provide proper education as to the proper use of these products. Our last expert panel covered issues surrounding Best ETF Trading Practices. This afternoon we will tackle the basics of another often misunderstood topic: ETFs and Taxes.

This issue is especially timely at this juncture, with December 31 just six weeks away. So although you won't be filing your taxes for months, many of the actions you can take to save on your taxes and limit tax liabilities need to be carried out before fiscal 2010 winds down.

The event will work as follows: We'll spend the first 45 minutes or so discussing ETF tax issues with our two panelists, and then post some questions from our audience. Feel free to start posting questions as soon as the event begins. We'll select some of the most interesting ones and pose them to our panelists.

One disclaimer before we begin: While both of our panelists are seasoned financial professionals with much experience dealing with ETF tax-related issues, neither is a CPA. Every investor's personal situation is different. Before making personal investment decisions, please consult with your accountant and financial advisor.

I'll now turn things over to John Hoffman of PowerShares and Jerry Slusiewicz of Pacific Financial Planners. And of course, thanks for joining us!

John Hoffman (Invesco PowerShares): Thank you Jonathan, and good afternoon everyone and thank you for joining us today. My name is John Hoffman with Invesco PowerShares Capital Management LLC (“Invesco PowerShares”), and I work to oversee our execution and liquidity services group. I also work to cover our institutional clients across various channels including Endowments, Foundations, Pensions and Hedge Funds.

Invesco PowerShares Capital Management is leading the Intelligent ETF Revolution through its family of more than 120 domestic and international exchange traded funds, which seek to outperform traditional benchmark indexes while providing advisors and investors access to an innovative array of focused investment opportunities. With franchise assets over $44 billion as of June 30, 2010, PowerShares ETFs trade on both U.S. stock exchanges.

The ETF product continues to gain traction as investors become familiar with this benefit rich investment vehicle, and I am excited to join you today to discuss the ETF in the context of taxes.

However, before we get started, I want to clarify that Invesco PowerShares Capital Management and Invesco distributors, Inc. and their affiliates do not provide tax advice. Please note that (i) any discussion of U.S tax matters contained in this communication can not be used for the purposes of avoiding tax penalties, and (ii) you should seek tax advice based on your particular circumstances from an independent tax advisor.

Taxes may be the most overlooked and critical factor in wealth creation. Every year at this time, we spend a lot of time working with investors to help them understand the ETF as it relates to taxes. Generally two major themes emerge:

  1. Why or how is the ETF tax efficient?
  2. How do I utilize ETFs in tax-efficient strategies?

While there is uncertainty in what the tax code will look like next year, it is certain that taxes will remain a significant cost to investors' portfolios. Tax planning and executing tax strategies may be especially important this year given potential tax code changes.

And although investment decisions should not be made solely for tax purposes, we believe tax implications should be considered in the decision making process.

I look forward to our discussion today, and hope to provide some insight on why the ETF is a tax efficient investment vehicle - and answer any questions you may have related to ETF as it pertains to taxes.

Jerry Slusiewicz: My name is Jerry Slusiewicz. I am the founder and President of Pacific Financial Planners. Thanks for having me!

Taxes play a very integral part of the investment process. As a financial planner, it is very critical to use write-offs, and pair long term capital gains and losses against short term gains and losses. This can help increase your income and improve overall portfolio performance.

Why ETFs are tax efficient

Jonathan Liss, SA Editor: Let's start with the most basic of questions. What makes the ETF a tax efficient investment vehicle? How do ETFs stack up against standard open-ended mutual funds?

John Hoffman (Invesco PowerShares): For years the media has been reporting that ETFs are tax efficient, and often they cite that this efficiency is based on the fact that ETFs are index-based, and thus the low turnover leads to tax efficiency. Although this may contribute to the tax efficiency of the ETF, this is not the major factor in why ETFs are tax efficient.

ETFs, when compared to mutual funds, offer tax efficiencies because of their unique product structure - and the efficiency is specifically recognized in the creation and redemption process. Structural differences between a mutual fund and an ETF can significantly affect the taxable capital gain distribution.

So what does this mean for shareholders?

The ETF structure has two unique traits:

  1. The in-kind redemption process enables the fund manager to remove the lowest cost-basis securities through stock transfers during the creation and redemption process and rebalancing.
  2. Unlike mutual funds, shares of ETFs are traded on an exchange in the secondary market, just like a stock. When one investor sells ETF shares and other investor buys them on the exchange, the underlying securities of the ETF don’t need to be sold in order to raise cash for the redemption.

The first point above is very important and not widely understood, so I want to elaborate on it as it is really important when we look at why an ETF is tax-efficient relative to mutual funds.

ETFs create and redeem in creation unit size (generally 50,000 shares of the ETF). On a creation unit done in-kind (as opposed to "cash only creations"), authorized participants (A. Ps) deliver the basket of underlying securities to the ETF sponsor''s custodian, and in-turn the A.P receives 50,000 shares of the ETF. And on an in-kind redemption, the A.P delivers 50,000 shares of the ETF to the custodian and receives the underlying securities that comprise this basket.

The transfer of shares as described here occurs in-kind - and this is the operative word: in-kind. This in-kind transfer between the ETF Trust and the A.P is not an execution and thus does not trigger a taxable event. This is very important because it is this in-kind transfer that is unique and what may provide the tax efficiency within the ETF.

For example, if you redeem your mutual fund shares, the portfolio manager may need to raise cash to meet your redemption by selling securities. This may generate a capital gain as the portfolio manager must execute in the market in order to raise the cash required for your redemption.

Let's compare this process to the sequence of events in the ETF product. In the ETF structure, the portfolio manager can transfer out the lowest-cost-basis securities during normal redemptions through this in-kind process. Let's look at a hypothetical situation to isolate this efficiency:

  1. You (the investor) sell 1,000 shares of the ETF.
  2. A market maker buys the 1,000 shares from you.
  3. At the end of the day, the market maker has bought 50,000 shares of the ETF from investors who have sold in the market.
  4. The market maker redeems 50,000 shares of the ETF by delivering 50,000 ETF shares to the ETF provider's custodial bank.
  5. Through an in-kind transfer, the market maker receives the underlying stock that comprises this portfolio.
  6. The stock that is transferred from the custodial bank to the market maker may be the lowest cost basis stock leaving the portfolio with the highest cost basis stock.

Similarly, during rebalances the ETF manager can utilize this in-kind transfer to get rid of the lowest-cost-basis securities in the portfolio.

Overall, the result may be greater tax efficiency because shareholder activity and the resulting portfolio turnover don't affect the portfolio to the same extent as with mutual funds. These traits can also mean a substantial difference in the after tax rate of returns from a mutual fund versus an ETF - even if both replicate the same underlying index. For example, Lipper estimates that taxable equity and fixed-income mutual fund share holders, who hold almost 50% of all mutual fund assets, surrendered approximately 40% and 49%, respectively, of their load-adjusted 10-year returns to taxes.

Understanding the structural differences between ETFs and mutual funds may help shareholders understand how tax treatment differs for each type of investment.

Jerry Slusiewicz: ETFs are tax efficient due the creation unit structure. However it is important to note that while internally ETFs are very tax efficient and transparent an individual investor is still subject to short- or long-term gains and losses depending on the price they pay. If someone bought SPY back on July 1, 2010 at the low at $101.13 and sold today before the close at $118.22, he is still subject to paying taxes on a short-term gain of $17.09 per share. This is taxed as ordinary income!

Had they bought SPY over a year ago - say early October 2009 at $103 - the gain would have been less, but the investor would have been subject only to a long-term capital gain tax of federally 15%.

What about capital gains distributions?

Jonathan Liss, SA Editor: On rare occasions, certain ETFs end up paying out large capital gains distributions at year-end that results in investors being taxed at the standard rate even if they didn't sell. Why is that?

John Hoffman (Invesco PowerShares): Great question. We already talked about the idea that the ETF is tax efficient stemming from the ability to in-kind transfer low-cost-basis names during creations, redemptions and rebalances. In 2009 for example, 116 of Invesco PowerShares 117 U.S listed ETFs issued zero capital gains. Nonetheless, not all ETFs are able to mitigate capital gains distributions. For example, some ETFs hold futures or swaps or other derivatives that may not be transferred in-kind, and thus may create and redeem for cash. So for example, an ETF that holds a swap may rally 20% and then large redemptions come in and the manager is forced to close out of the swap at a 20% gain to meet the cash redemptions. This is an extreme example. However, products that create and redeem in cash have may have less ability to mitigate capital gains distributions as they may not transfer low-cost-basis securities through the in-kind process.

Tax loss/ tax gain harvesting

Jonathan Liss, SA Editor: Let's move on to how ETFs are utilized in tax efficient strategies. Jerry can you address tax loss harvesting and tax gain harvesting as I know you deal with this a lot in your practice.

Jerry Slusiewicz: Jonathan - this is an excellent question. Tax loss harvesting is often the most overlooked aspect of financial planning. Many investors believe in buy-and-hold, and can miss out on opportunity that could most definitely improve their returns.

Slide one shows someone who bought SPY, but instead of holding took the loss prior to the end of the year - 2008:

Slide 2 shows that by sharing this loss with Uncle Sam on your tax return - the loss is lowered by the $25,128 write off to be taken on your tax return - if you are in the highest tax bracket. (Because I am not an accountant and everyone's situation is different, please check with your own CPA.)

Here is another disclaimer: IRS wash sale rules state that you cannot use a "substantially identical stock" to replace the one you sold. But due to fee structures etc., one can argue that IVV or an open-end SPY 500 index fund is not the same as SPY - so check with your accountant about what is and what is not a “substantially identical stock” or you could wait 31 days to avoid “wash sales rules”.

But had someone replaced SPY with IVV on the same day to maintain his financial interest, and sold yesterday, the new purchase would have netted a profit of 44%.

So the buy-and-hold investor through yesterday has a loss of 26.4%, but through prudent tax loss harvesting the other investor is almost at break even - while the markets are still substantially down! (Check with your accountant!)

John Hoffman (Invesco PowerShares): At Invesco PowerShares we offer two tools on our website for investors to be able to conduct analysis via correlation and holdings overlap.

At www.PowerShares.com > Tools > Correlation Tracker we have a correlation tracker that will show you which ETFs have the highest and lowest correlation to a particular security. This tool can be found at: http://www.invescopowershares.com/tools/correlation.aspx.

Alternatively, we have another tool on www.powershares.com that enables investors to look at which ETFs have the largest weighting to a single security. This tool can be found by going to www.powershares.com > Tools > Stock Screener or by following this link: http://www.invescopowershares.com/tools/screener.aspx.

Jerry Slusiewicz: The inverse of Tax Loss Harvesting is Tax Gain Harvesting. This is the time of year to do both!

We send a letter to our clients asking if they have any substantial long- or short-term gains or losses that we should know about, and have that discussion each and every year. Then we look at the portfolio to see how they stack up internally from a tax perspective before December 31.

If someone has a net taxable gain in their portfolio, many times we will offset that gain by selling any positions with losses prior to the end of the year. It is important that we sell short-term positions against short-term gains, and long-term positions against long-term gains. This effectively attempts to collapse the amount of taxes due before the end of the year.

John Hoffman (Invesco PowerShares): Jerry, to add to that point, this year we have heard some investors discuss the idea of tax gain harvesting whereby they are harvesting gains at today's rates in anticipation that tax rates will be rising in the future.

The wash sale rule

Jonathan Liss, SA Editor: What is the wash sale rule? How can one use ETFs within the wash sale rule?

John Hoffman (Invesco PowerShares): When utilizing a tax-swap strategy, investors must be careful not to trigger a wash sale, which would disallow the loss from being recognized. A wash sale could be triggered if the investor purchases what is deemed as a "substantially identical" security 30 days prior to or after the sale of the security for a loss. The IRS has not provided definitive guidelines regarding what is deemed as a "substantially identical" security, particularly as it pertains to ETFs. It is important to consult a tax professional to determine if a specific security or tax-swap strategy would result in a wash sale.

Jerry Slusiewicz: Right - watching the wash sale rules is very important.

In general you have a wash sale if you sell stock at a loss, and buy substantially identical securities within 30 days before or after the sale. The wash sale period for any sale at a loss consists of 61 days: the day of the sale, the 30 days before the sale, and the 30 days after the sale. These are calendar days, not trading days. Count carefully. If you repurchase the same security within that 30 day period – you negate the write off.

I have at times used ETFs from another company to maintain an interest in the position should I still want exposure to that sector. However, it is important that you understand the IRS rules regarding "substantially identical securities." I believe that another carrier - different fee structures and perhaps different stock weightings make two ETFs in the same sector different - but always ask your own accountant!

Jonathan Liss, SA Editor: So would two ETFs that track the same index - say EEM and VWO - generally be considered 'substantially identical'?

Jerry Slusiewicz: It depends on who you ask; according to me no. But I'm not an accountant. They are structured differently - different fees - etc. There's some debate, but no direct authority, on the question of whether two mutual funds or ETFs keying off the same index are substantially identical for purposes of the wash sale rule. The safe final comment regarding wash sale rules is to wait 31 days!

Why different ETPs are taxed differently

Jonathan Liss, SA Editor: There has especially been confusion among investors as to what rates commodity ETFs and ETNs get taxed at. I'm going to insert a graphic here showing the rates at which different commodity ETPs are taxed:

Why do different commodity ETPs get different tax treatments - for example physical metal funds vs. futures-based ETFs? How about ETFs vs ETNs?

John Hoffman (Invesco PowerShares): There are a few different ways to get commodity exposure inside the Exchange-Traded Products (ETP) structure. There are ETFs that hold the physical securities, and there are ETFs that are comprised of futures. So, for example, the SPDR Gold Trust (NYSEARCA:GLD) holds physical gold, and is taxed as a collectable at the 28% rate. We have a gold ETF in conjunction with Deutsche Bank (NYSE:DGL) that holds gold futures. For tax purposes, the futures are marked to market at year-end, and 60% of the gain is taxed at the investors long-term rate, and 40% of the gain is taxed at the investors short-term rate. So, for example, an investor who holds DGL, if you assume they are in the 35% bracket, their effective rate on DGL would be (0.6 x 0.15) + (0.4 x 0.35) - or effectively 23%.

In addition, for Registered Investment Companies, within the meaning of Section 851 of the Internal Revenue Code of 1986, as amended, that may want to invest in DGL, they should reference the following link for estimates: http://dbfunds.db.com/dgl/regcompanies.aspx

Investors can also attain exposure to commodities through Exchange Traded Notes (ETNs). Exchange Traded Notes are unsecured promises by the issuer to pay a rate of return that is tied to the change in the value of the underlying index. Although ETFs and ETNs are similar in many ways, they are structurally very different. An ETN represents an unsecured claim on the issuing firm (debt), while an ETF represents a secured claim on the underlying asset. I need to remind the PowerShares DB ETNs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk.

There are a number of ETNs that provide exposure to commodities as well. For example, Invesco PowerShares has expanded it marketing partnership with Deutsche Bank to include a series of ETNs which provide exposure to commodities. Currently, these products generate a 1099 and are not taxed at the futures rate I described above.

So when you are looking at attaining commodity exposure, you should evaluate whether the vehicle is an ETF or ETN, and if it is an ETF, whether it holds physical or futures, as the tax consequences for each combination are different.

Taxes on muni bond ETFs

Jonathan Liss, SA Editor: How are muni bond ETFs taxed vs. other types of government bond funds? What's the likelihood of a year-end capital gains distribution on these funds?

Jerry Slusiewicz: Muni bonds invest in federally tax-free securities - depending on the state you live in they can be state tax exempt as well. There can be potential for capital gains if certain bonds within the ETF are called at a premium, or if there is some internal selling within the fund on bonds at a profit. That could happen for a variety of reasons, but it is still most likely a rare event.

Government bond funds pay income that is taxed at the investor's ordinary income rate, like earnings from a job. Just like the municipal ETFs, there can be capital gains on government ETFs depending on the internal functions of the portfolio. Calls and internal sales at profits could create a year-end capital gain - but are mostly rare.

John Hoffman (Invesco PowerShares): Jerry, to add to your muni bond comments: Invesco PowerShares offers a National Insured Muni Bond ETF (NYSE:PZA), PowerShares Insured New York Municipal Bond Portfolio (NYSE:PZT), and PowerShares Insured California Municipal Bond Portfolio (NYSE:PWZ).

Subtracting mortgage payments from ETF gains?

Question from a guest: I remortgaged my home and bought ETFs with the extra money. Since I now pay more in interest on my home mortgage, can I subtract the difference from my gains in the stock market?

Jerry Slusiewicz: I'm not an accountant - but the interest on your mortgage is already fully deductible on your taxes. Stock gains would still be in addition to your write-off of your interest; you cannot deduct your mortgage interest twice!

ETFs that shouldn't go into a tax-deferred account

Question From optionsgirl: Are there any ETP's that should not go into a tax-deferred (retirement) account?

Jerry Slusiewicz: I don't recommend putting muni funds into qualified accounts as they are tax deferred already.

optionsgirl: I was referring to the possibility of any that generate K-1's?

John Hoffman (Invesco PowerShares): The ETF provider does not have the ability to determine what type of account the securities are held in. As a result, if tax forms are generated from owning a particular ETP (K-1s, 1099, etc.), they will be delivered to the holder of record regardless of the account structure. We encourage you to consult your tax professional as it relates to holding these securities in qualified accounts.

Jonathan Liss, SA Editor: As a general rule though, K-1s like 1099s would be exempt from all taxes if held in an IRA.

ETF tax strategies for lower-bracket investors

Question from Steve: I noticed that many of the examples are for those in the 35% tax bracket. Do these strategies change significantly if you're in a lower bracket?

Jerry Slusiewicz: No - if you are in a lower tax bracket, the impact of taxes may be less, which in many cases is better for you. However, tax loss harvesting and active portfolio management is, in my opinion, always prudent. It is better to share your loss with the IRS and minimize your gains to reduce the amount you owe - no matter what tax bracket you are in.

Jonathan Liss, SA Editor: Thanks everyone for joining us this evening. John and Jerry, thanks for taking time out of your busy schedules. This has been a very informative and timely conversation.

Jerry Slusiewicz: Jonathan, thank you very much for having me on this forum. You are doing a great service for your audience. If anyone has any further questions, they can contact me via email or through my toll-free number and I will do my best to answer their questions. Thanks again.

John Hoffman (Invesco PowerShares): Thanks Everyone!