Exchange-traded funds (ETFs)are giving mutual funds a run for investors' money because ETFs get around the tax hit that investors in mutual funds encounter. Mutual fund investors pay capital gains taxon assets sold by their funds. ETFs, however, don't subject investors to the same tax policies. ETF providersoffer shares"in kind," with authorized participants abuffer between investors and theproviders' trading-triggered tax events.
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.
- ETFs can avoid the wash sale rule because ETFs typically are an index for a sector or a group of stocks and are not "substantially identical" to a single stock.
The Wash-Sale Rule
Investors who buy a "substantially identical security"within 30 days before or after selling at a loss are subject to the wash-sale rule. The rule prevents an investor from selling a security at a loss, booking that loss to offset the tax bill, and then immediately buying the security back at, or near, the sale price.
ETF investors enjoy an advantage that worries Harold Bradley, once Kauffman Foundation's chief investment officer from 2007 to 2012. "It's an open secret," he told Investopedia. "High net worth money managers now are paying no taxes on investment gains. Zero."Bradley says that ETFs are used to avoid the IRS' wash-sale rule.
Enforcing IRS Rules
According to Bradley, the wash-sale rule is not enforced forETFs. "How many sponsors are there of an ETF?" he asks. Most indices have threeETFsto track them—ignoring leveraged, short, and currency-hedged variations—each provided by adifferent firm.
That makes itpossible to sell, for example,the Vanguard S&P 500 ETF (VOO) at a 10% loss, deduct that loss and buy theiShares S&P 500 ETF (IVV) immediatelywith the underlying index at the same level. "You basically can take a loss, establish it, and not lose your market position."
Michael Kitces, the author of the Nerd's Eye View blog on financial planning, told Investopedia by email that "anyone who (knowingly or not) violates those rules remains exposed to the IRS," but "there's no tracking to know how widespread it is."
Kitces points out that, from the IRS' perspective, a "widespread illegal tax loophole" translates to a "giant target for raising revenue." An IRS spokesperson told Investopediaby phone that the agency does not comment on the legality of specific tax strategies through the press.
Bradley is not so sure, though. "High net worth people don't have any interest in having the government understand" the loophole, which he thinks is"the biggest driver of ETF adoption by financial planners. Period. They can justify their fees based on their 'tax harvesting strategies.'"
The Growth of ETFs
If Bradley is right, the implications of this practice go beyondtax-dodging by the wealthy. So much capital has flowed into index-tracking ETFs, he says, that markets "are massively broken right now." Money has poured out of individual stocks and into ETFs, leading to "massive" valuation distortions,
Bradley argues:"The meteoric rise in Low Volatility ETFs(150% annual asset growth since 2009) as a key driver of the 200%+ surge in relative valuations of low beta stocks to never-before-seen premia." The problem is not limited tolow-beta stocks, Bradley says. "People have never paid more for a penny of dividends. People have never paid more for earnings, people have never paid more for sales. And all of this is a function of people believing that someone else is doing active research."
Bradley is not optimistic. "You are undermining the essential price discovery feature that has been built into stocks over time that says, this is a good entrepreneur who's really smart, and he needs money to grow and build his company. That's been lost as a primary driver of the capital markets."
U.S.-listed ETFs andexchange-traded notes (ETNs)ballooned from about $102 billion in 2002 to $6.44 trillion in 2022. Total net assets for mutual funds in 2022 were approximately $22.1 trillion.
What Is a Tax Loss Harvesting Strategy?
Tax loss harvesting is a tax strategy that involves selling an asset with a capital loss to lower or eliminate the capital gain realized by other investments for income tax purposes.
Why Can ETFs Avoid the Wash-Sale Rule?
ETFs can avoid the wash sale rule because ETFs typically are an index for a sector or a group of stocks and are not "substantially identical" to a single stock.
When Are Two Investments Considered "Substantially Identical"?
The term "substantially identical security" pertains to tax rules published by the U.S. Internal Revenue Service (IRS) regarding wash sales. Substantially identical securities are not different enough to be separate investments. Securities usually fall into this category if the market and conversion prices are the same and cannot be counted in tax swaps or other tax-loss harvesting strategies.
The Bottom Line
Exchange-traded funds are structured in a way that avoids the wash sale rule because the investments are typically tied to an index for a group of stocks and are not "substantially identical" to a single stock. As of 2022, investors held over $6 trillion in ETFs.
FAQs
ETFs can be used to avoid the wash sale rule while maintaining a similar investment holding. This is because ETFs typically are an index for a sector or other group of stocks and are not substantially identical to a single stock.
What is the ETF tax loophole? ›
Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.
Do you pay taxes on ETFs if you don't sell them? ›
If you hold these investments in a tax-deferred account, you generally won't be taxed until you make a withdrawal, and the withdrawal will be taxed at your current ordinary income tax rate. If you invest in stocks and bonds via ETFs, you probably won't be in for many surprises.
Can you do tax-loss harvesting with ETFs? ›
Tax-loss harvesting is the process of selling securities at a loss to offset a capital gains tax liability in a very similar security. Using ETFs has made tax-loss harvesting easier because several ETF providers offer similar funds that track the same index but are constructed slightly differently.
How does the IRS know about wash sales? ›
Note: Wash sales are in scope only if reported on Form 1099-B or on a brokerage or mutual fund statement. Click here for an explanation. A wash sale is the sale of securities at a loss and the acquisition of same (substantially identical) securities within 30 days of sale date (before or after).
Does the wash rule apply to ETFs? ›
Exchange-traded funds are structured in a way that avoids the wash sale rule because the investments are typically tied to an index for a group of stocks and are not "substantially identical" to a single stock. As of 2022, investors held over $6 trillion in ETFs.
How to avoid paying taxes on ETFs? ›
One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.
What is the wash sale rule for mutual funds to ETF? ›
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
Do you pay capital gains when you sell an ETF? ›
ETF capital gains taxes
Of course, investors who realize a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%.
Why are there no capital gains on ETFs? ›
Why? For starters, because they're index funds, most ETFs have very little turnover, and thus amass far fewer capital gains than an actively managed mutual fund would. But they're also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.
What is the downside of tax-loss harvesting? ›
Overlooking How Tax-Loss Harvesting Emphasizes Losses
Another downside to tax-loss harvesting is that it highlights the exact outcome clients are hoping to avoid – investment losses. In contrast, capital-gains harvesting, or strategically selling investments at a gain, emphasizes the wins in your clients' portfolios.
Does Vanguard offer tax-loss harvesting? ›
Tax-loss harvesting is included in your Vanguard Personal Advisor fee. Is this a new investment strategy?
How do I avoid wash sales tax? ›
If you have a wash sale, however, you cannot claim the write-off until you finally sell the asset and avoid repurchasing it for at least 30 days. After that period, you can re-buy the asset without triggering the wash-sale rules.
Does the IRS audit wash sales? ›
While in the short-term, they may avoid the wash sale loss problem, over the long-term, it will not work out well for the brokers or the clients. The IRS will probably audit some of their clients over wash sales and agents will likely propose tax changes, including tax liability, penalties and interest.
Do brokers report wash sales to the IRS? ›
Wash Sales and Activity Statements
Interactive Brokers includes wash sales on daily, monthly and annual Activity Statements for all 1099-eligible accounts, as required by the IRS.
Do I need to pay taxes on ETFs? ›
Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.
What is the tax advantage of ETF? ›
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
How much tax do you pay on ETF earning? ›
ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor's income tax rate.
What is the 30 day rule on ETFs? ›
Reinvesting in a different ETF can be a way of upgrading or repositioning that investment. However, if you sell shares of an ETF and buy back into another ETF that tracks the same index within 30 days, you may likely trigger the superficial loss rule.
