Personal Finance
When exchange-traded funds really flex their ‘tax magic’ for investors
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Investors can generally reduce their tax losses in a portfolio by using exchange-traded funds over mutual funds, experts said.
“ETFs come with tax magic that’s unrivaled by mutual funds,” Bryan Armour, Morningstar’s director of passive strategies research for North America and editor of its ETFInvestor newsletter, wrote earlier this year.
But certain investments benefit more from that so-called “magic” than others.
Tax savings are moot in retirement accounts
ETFs’ tax savings are typically greatest for investors in taxable brokerage accounts.
They’re a moot point for retirement investors, like those who save in a 401(k) plan or individual retirement account, experts said. Retirement accounts are already tax-preferred, with contributions growing tax-free — meaning ETFs and mutual funds are on a level playing field relative to taxes, experts said.
The tax advantage “really helps the non-IRA account more than anything,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida, and a founding member of Moisand Fitzgerald Tamayo.
“You’ll have tax efficiency that a standard mutual fund is not going to be able to achieve, hands down,” he said.
The ‘primary use case’ for ETFs
Mutual funds are generally less tax-efficient than ETFs because of capital gains taxes generated inside the fund.
Taxpayers who sell investments for a capital gain (i.e., a profit) are likely familiar with the concept of paying tax on those earnings.
The same concept applies within a mutual fund: Mutual fund managers generate capital gains when they sell holdings within the fund. Managers distribute those capital gains to investors each year; they divide them equally among all shareholders, who pay taxes at their respective income tax rate.
However, ETF managers are generally able to avoid capital gains taxes due to their unique structure.
The upshot is that asset classes that generate large capital gains relative to their total return are “a primary use case for ETFs,” Armour told CNBC. (This discussion only applies to buying and selling within the fund. An investor who sells their ETF for a profit may still owe capital gains tax.)
Why U.S. stocks ‘almost always’ benefit from ETFs
U.S. stock mutual funds have tended to generate the most capital gains relative to other asset classes, experts said.
Over five years, from 2019 to 2023, about 70% of U.S. stock mutual funds kicked off capital gains, said Armour, who cited Morningstar data. That was true of less than 10% of U.S. stock ETFs, he said.
“It’s almost always an advantage to have your stock portfolio in an ETF over a mutual fund” in a non-retirement account, Armour said.
U.S. “growth” stocks — a stock sub-category — saw more than 95% of their total return come from capital gains in the five years through September 2024, according to Morningstar. That makes them “the greatest beneficiary of ETFs’ tax efficiency,” Armour said.
Large-cap and small-cap “core” stocks also “benefit considerably,” with about 85% to 90% of their returns coming from capital gains, Armour said.
About 25% to 30% of value stocks’ returns come from dividends — which are taxed differently than capital gains within an ETF — making them the “least beneficial” U.S. stocks in an ETF, Armour said.
“They still benefit substantially, though,” he said.
ETF and mutual fund dividends are taxed similarly. ETF dividends are taxed according to how long the investor has owned the fund.
Actively managed stock funds are also generally better candidates for an ETF structure, Fitzgerald said.
Active managers tend to distribute more capital gains than those who passively track a stock index, because active managers buy and sell positions frequently to try to beat the market, he said.
However, there are instances in which passively managed funds can trade often, too, such as with so-called “strategic beta” funds, Armour said.
Bonds have a smaller advantage
ETFs are generally unable to “wash away” tax liabilities related to currency hedging, futures or options, Armour said.
Additionally, tax laws of various nations may reduce the tax benefit for international-stock ETFs, like those investing in Brazil, India, South Korea or Taiwan, for example, he said.
Bond ETFs also have a smaller advantage over mutual funds, Armour said. That’s because an ample amount of bond funds’ returns generally comes from income (i.e., bond payments), not capital gains, he said.
Fitzgerald says he favors holding bonds in mutual funds rather than ETFs.
However, his reasoning isn’t related to taxes.
During periods of high volatility in the stock market — when an unexpected event triggers a lot of fear selling and a stock-market dip, for example — Fitzgerald often sells bonds to buy stocks at a discount for clients.
However, during such periods, he’s noticed the price of a bond ETF tends to disconnect more (relative to a mutual fund) from the net asset value of its underlying holdings.
The bond ETF often sells at more of a discount relative to a similar bond mutual fund, he said. Selling the bond position for less money somewhat dilutes the benefit of the overall strategy, he said.
Jaque Silva/ | Nurphoto | Getty Images
With the price of bitcoin down from a record high in January, there’s a chance for some investors to score a tax break, experts say.
Following a post-election rally, the flagship digital currency touched $109,000 on inauguration day before falling in February. As of midday Friday, the price was around $84,000, after dipping below $80,000 overnight, according to Coin Metrics.
The latest selloff presents a tax planning opportunity, including a “loophole” that could go away amid Congressional tax negotiations, according to Andrew Gordon, a tax attorney, certified public accountant and president of Gordon Law Group.
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The strategy, known as “tax-loss harvesting,” allows you to offset profitable investments by selling declining assets in a brokerage or other taxable account. Once your losses exceed gains, you can subtract up to $3,000 per year from regular income and carry excess losses into future years.
Some investors wait until December for tax-loss harvesting, which can be a mistake because asset volatility, particularly for digital currency, happens throughout the year, experts say.
“You should look for these opportunities continually and take advantage of them as they occur,” Gordon said.
You should look for these opportunities continually and take advantage of them as they occur.
Andrew Gordon
President of Gordon Law Group
The crypto wash sale ‘loophole’
When selling investments, there’s a wash sale rule, which blocks you from claiming a loss if you repurchase a “substantially identical” asset within a 30-day window before or after the sale.
But currently, the wash sale rule doesn’t apply to cryptocurrency, which can be beneficial for long-term digital currency investors, experts say.
“If you sell, for instance, bitcoin at a loss today and then buy it back tomorrow, you still have your loss on the books,” Gordon said. “This is an extremely effective strategy for crypto investors because they don’t have to exit their position.”
However, the strategy could disappear in the future as Congressional Republicans seek ways to fund President Donald Trump‘s tax agenda.
Sens. Cynthia Lummis, R-Wyo. and Kirsten Gillibrand, D-N.Y., in 2023 reintroduced a regulatory framework for cryptocurrency, which included closing the crypto wash sale loophole. Former President Joe Biden‘s fiscal year 2025 budget also included the proposal.
In the meantime, “the IRS gives us this loophole. We may as well take it,” Adam Markowitz, an enrolled agent at Luminary Tax Advisors in Windermere, Florida, previously told CNBC.
Of course, you should always consider your investing goals and timeline before implementing the tax strategy.
Pra-chid | Istock | Getty Images
With tax season well underway, you may be eager for strategies to reduce your 2024 taxes or boost your refund. However, there are limited options, especially for so-called “W-2 employees” who earn wages, experts say.
After Dec. 31, there are “very few” tax moves left for the previous year, according to Boston-area certified financial planner and enrolled agent Catherine Valega, founder of Green Bee Advisory.
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Don’t wait to file your taxes this season, experts say. Here’s why
Once the calendar year ends, it’s too late to claim a tax break by boosting 401(k) plan deferrals, donating to charity or tax-loss harvesting.
But there are a few opportunities left before the April 15 tax deadline, experts say. Here are three options for taxpayers to consider.
1. Contribute to your health savings account
If you haven’t maxed out your health savings account for 2024, you have until April 15 to deposit money and score a tax break, experts say.
For 2024, the HSA contribution limit is $4,150 for individual coverage or $8,300 for family plans. However, you must have an eligible high-deductible health insurance plan to qualify for contributions.
“The HSA is easy,” said CFP Thomas Scanlon at Raymond James in Manchester, Connecticut. “If you are eligible, fund it and take the deduction.”
2. Make a pre-tax IRA deposit
The April 15 deadline also applies to individual retirement account contributions for 2024. You can save up to $7,000, plus an extra $1,000 for investors age 50 and older.
You can claim a deduction for pre-tax IRA contributions, depending on your earnings and workplace retirement plan.
The strategy lowers your adjusted gross income for 2024, but the account is subject to regular income taxes and required withdrawals later, said CFP Andrew Herzog, associate wealth manager at The Watchman Group in Plano, Texas.
“A traditional IRA simply delays taxation,” he added.
A traditional IRA simply delays taxation.
Andrew Herzog
Associate wealth manager at The Watchman Group
3. Leverage a spousal IRA
If you’re a married couple filing jointly, there’s also a lesser-known option, known as a spousal IRA, which is a separate Roth or traditional IRA for nonworking spouses.
Married couples can max out a pre-tax IRA for both spouses, assuming the working spouse has at least that much income. It’s possible to claim a deduction for both deposits.
But whether you’re making a single pre-tax IRA contribution or one for each spouse, it’s important to weigh long-term financial and tax planning goals, experts say.
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