More and more investors are looking for control and tax advantages for ETFs. And the rising tide of funds flowing into ETFs could soon turn into a tsunami. As a result, you may want to catch the wave.
ETFs have been a popular investment method since they were launched in the early 1990s. Today there are over 7,600 ETFs full of trillions of investment dollars.
What is an ETF?
An ETF (Exchange Traded Fund) is a Security that tracks an index, commodity, bond, sector, or other asset. It owns the underlying assets and divides ownership of those assets into stocks that investors buy.
A key difference between ETFs and mutual funds is that ETFs are traded on a stock exchange like stocks. As a result, the price of an ETF can fluctuate during the trading day. Investment funds, on the other hand, are traded once a day after the market closes.
ETFs have become popular with low operating costs resulting in no or low fees. Plus, they offer diversification as many ETFs invest in an index like the S&P 500. However, some ETFs focus on a single industry, which limits diversification.
Flow goes to ETFs
According to Morning star, an investment research and management firm, has invested more investor money in ETFs than in mutual funds over eight of the last 10 years. In fact, over $ 900 billion has left mutual funds and $ 1.8 billion has flowed into ETFs during that time.
ETFs work similarly to mutual funds in that they have investment portfolios. On the other hand, ETFs are more liquid and easier to trade than mutual funds.
The tax complaint
The popularity of ETFs is expected to increase in the coming years. This is due, at least in part, to high net worth investors seeking the control and tax advantages of ETFs.
President Joe Biden has proposed raising the highest income tax rate for people who earn over $ 400,000 a year from 37 percent to 39.6 percent. He also wants to tax long-term capital gains and qualifying dividends at the normal income tax rate of 39.6 percent on income above $ 1 million.
The prospect of higher taxes has made wealth investors looking for ways to generate high returns with little or no tax ramifications. You have found ETFs.
Tax advantages of ETFs
The way ETF stocks are sold has the interest of high net worth investors. This is how it works.
If you own shares in a mutual fund and want to get out, the fund manager must sell your shares in the open market. As a result, you may have to pay taxes on winnings.
With an ETF, you sell your shares directly to another investor. In this way, neither you nor the Fund have entered into a taxable transaction.
Well, you say, aren’t we happy for Richie Rich and his friends? But I’m not in the upper tax bracket. Why should I care about ETFs?
Good question. You may like ETFs because most of them trade with no commission, have lower operating costs, and are more flexible. This is the control part of the “Control and Tax Benefits of ETFs”.
Conversion of mutual funds into ETFs
ETFs are becoming so popular that you may already be investing in one without doing anything. This is because some mutual funds have been converted into ETFs.
History was written in late March when two Guinness Atkinson Asset Management mutual funds have been converted into ETFs. In addition, Dimensional Fund Advisors announced that it will convert six tax-managed funds into ETFs. That will begin on June 11th, when four funds will make the transformation. More conversions are expected, according to Ben Johnson. Morningstars Director of Global ETF Research.
“Many of the benefits of converting a mutual fund into an ETF are synonymous with the benefits of the ETF wrapper. It’s about where that money will ultimately end up, the packaging, the shape that it will ultimately take. And I would argue that the most important thing is the relative tax efficiency of ETF packaging versus mutual fund packaging, ”Johnson said in one current Morningstar podcast. “You avoid unlocking capital gains distributions, which have become very common and in some cases very large in the mutual fund space in recent years. That’s a huge benefit that would come from converting a mutual fund into an ETF. “
Tax implications of converting mutual funds
The withdrawal of your mutual fund can create a tax burden. However, this is not the case with a mutual fund conversion, says Johnson.
“A mutual fund’s conversation with an ETF will not be a chargeable event for mutual fund shareholders,” said Johnson. “Your base will remain intact. Ultimately, what investors will enjoy is a form of tax deferral that they would not otherwise benefit from if this fund remained a mutual fund. This continues in some cases in persistent outflows that have resulted in these large outflows in recent years and regular distributions of capital gains. “
Everyone in the pool?
You might think that given the lower costs and tax benefits, all mutual funds would convert to ETFs. However, some mutual funds simply cannot.
Many mutual funds have multiple share classes spread across multiple platforms. These elements make the conversion difficult. However, other funds are in pension and other retirement programs. You cannot convert to ETFs.
So are the heyday of mutual funds over? The prime times, yes, but they won’t go away. Retirement accounts like 401 (k) s and other retirement accounts will likely continue to use mutual funds. After all, they are already tax-privileged. In addition, it is easier for managers to keep records.
For individual investors, however, the future points to ETFs.
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