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ETFs 109: How Exchange-Traded Funds Keep the Taxman at Bay

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1.
Most ETFs are index funds. How does this affect their taxability?
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They don't trade their underlying securities very often, which means fewer taxable gains. Fewer capital gains mean fewer taxes.
2.
ETFs are tax-efficient because _______.
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The indexes most ETFs track have low turnover and the creation redemption process shields shareholders from the actions of others. ETFs do have low fees and are traded on an exchange but these characteristics do not make them tax efficient. ETFs rebalance their portfolios and many different intervals. ETFs traditionally have lower turnover then comparable mutual funds. The creation redemption process is the mechanism by which shares are created and redeemed in-kind, which reduces the need for the ETF to have to sell shares of underlying securities.
3.
In-kind redemptions are _______.
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Non-taxable. They are non-cash transactions in which shares of the ETF are exchanged for the underlying holdings.
4.
An ETF with a high turnover ratio is more likely to be tax inefficient?
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False. The more an index changes its holdings, the more the ETF tracking the index will have to change its portfolio, which increases the likelihood of taxable events when the ETF sells shares of underlying positions.
5.
How are ETFs that invest in futures contracts taxed?
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60% long-term gain and 40% short-term gain. Futures contracts are marked to market at the end of the year and any gains are taxed as 60% long-term and 40% short term capital gains.