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Can ETFs Help Reduce Taxes?

Now suppose an investor sells a stock ETF. To complete the transaction, the investor sells the shares on an exchange the way any stock is traded. If the investor recorded a gain, then the sale could produce a tax bill for him. But there would be no tax impact on the ETF portfolio. So investors who continue to own the ETF would not face bills.

The tax bills of many ETFs can be especially low because of the way that new shares are created and redeemed by institutions. Say an institution wants to redeem a large position in a fund that invests in the S&P 500. To accomplish the trade, the institution returns shares to the ETF. But the ETF portfolio manager does not pay in cash. Instead, the manager makes an in-kind exchange, providing actual shares of the 500 S&P stocks that are held by the fund. Because the fund does not sell any shares, there are no capital gains taxes.

In a bull market, the lack of capital gains can provide a significant edge for stock ETFs. But during the downturn of 2008, mutual funds had a tax advantage. In the turmoil of the financial crisis, many shareholders redeemed mutual fund shares. The funds were forced to sell stock at losses in order to raise cash. Those losses have stayed on the books and helped to offset capital gains. In contrast, the ETFs did not book many losses because of in-kind redemptions. As a result, many mutual funds have been more tax efficient than ETFs. Now that most of the tax losses have been used, the advantage of mutual funds could disappear.

Although stock ETFs can have a big tax advantage in bull markets, bond ETFs only enjoy a slight edge in good times. The advantage is limited because bond ETFs sometimes make redemptions in cash. To raise the cash, portfolio managers may have to sell bonds and record capital gains. Even if they make in-kind redemptions, bond ETFs have only a small edge over mutual funds because the fixed-income markets rarely produce big capital gains. If bonds record capital losses in coming years, as some economists expect, then mutual funds could enjoy a big tax advantage.

Should you avoid bond ETFs? Not necessarily. But you should shop carefully to find the ETFs and mutual funds that have demonstrated an ability to provide the most efficient solutions.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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