IV Lions writes: Let’s look at one common tax difference between exchange traded funds (ETFs) and mutual funds. Should an investor redeem their shares with a mutual fund, the fund will often need to sell some of the portfolio to meet the redemption request. If the assets sold generate capital gains (the manager sells the positions for more than they bought them), the fund is required by law to pass these on to remaining shareholders.
This redemption process carries on all year and if the net result is a year-end realized capital gain then this burden is reported to remaining shareholders, who may not be expecting a tax bill (especially if they bought their shares towards the end of the year, or the fund experienced large unrealized losses during the year – a real 2008 nasty).
The potential for this unexpected tax burden may be avoided with an ETF as the redemption process is different. ETFs may create and redeem shares with in-kind transactions that are not considered sales and therefore don’t create tax events. This is great news for the retail investor as it avoids the potential tax burden associated with mutual funds redemption process.
However, ETF’s are not all born equally and may have their own tax pitfalls which I will address in a separate blog. It is critical to understand the tax treatment of your ETF in order to avoid any surprizes such as an unexpected K1.
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