Tax Consequences of an ETF vs. a Closed End

Investing in ETFs can save taxpayers a lot of grief and money when filing their tax returns.

It's important to consider potential tax consequences when investing in a security. Dividends and interest payments are taxed as income, and any increases in the value of a security are taxed as capital gains when sold or when the gains from portfolio holdings are distributed, which typically occurs annually. Exchange-traded funds, or ETFs, and closed-end funds, or CEFs, are often compared as alternatives to mutual funds, but they do have many differences, including the tax consequences of their structure.

Similarities of ETFs and Closed-End Funds

ETFs and CEFs are both like mutual funds in that multiple investors pool their money together for investment. They generally own multiple securities, which can change over time. Unlike mutual funds, both ETFs and CEFs are traded on stock exchanges with an exclusive ticker symbol.

Differences between ETFs and Closed-End Funds

ETFs are generally passive instruments, which track the returns of a particular index. CEFs are actively managed by a portfolio manager who picks and chooses which securities to invest in to increase returns or reduce risk. CEFs also have a fixed number of shares available, which can lead to large premiums or discounts of the share price compared to the value of the funds' holdings. The number of shares in an ETF can fluctuate, so market makers are generally able to keep the price of the shares in line with the value of the underlying holdings.

Dividend Taxes

Just like with mutual funds or stocks, dividend payments from ETFs or CEFs are taxable. The dividends are currently taxable at the ordinary income tax rate for the individual, unless they are qualified dividends, which are taxed at 15 percent, as of 2011. To classify as qualified, dividends must be paid between January 1, 2003 and December 31, 2012 by a company based in the U.S. or traded on a U.S. exchange. Investors must also hold the security for more than 60 days in a 121-day period. The exception is set to expire in 2013.

Capital Gains Taxes

For securities held less than one year, capital gains are taxed at ordinary rates; securities held for greater than one year incur taxes at a rate of either 5 percent or 15 percent. Capital gains taxes are also charged on gains from sales of the underlying holdings of a fund and passed through to the fund investors. Because ETFs are passive index-tracking instruments, they generally have less turnover than actively managed CEFs, which buy and sell securities regularly. ETFs are therefore more tax-efficient as there is a smaller possibility for tax gain distributions.

References

• Morningstar: Mutual Funds or ETFs--Which to Choose?
• Morningstar: How ETFs Keep the Taxman at Bay