• ETFs offer individual investors money-saving tax advantages.Accounting and finance image by MAXFX from Fotolia.com
  
  Exchange-traded funds (ETFs) are index funds that trade like stocks. In relation to mutual funds, ETFs offer a number of potential tax advantages. The relative tax-efficiency of ETFs stems from the fact that sales of stock result in capital gains or losses.
  
  Investors may use capital losses to decrease their taxable income, but must pay taxes on capital gains. Short-term capital gains (from sales of investments held for less than one year) are taxed at the investor's ordinary income-tax rate. Long-term capital gains are taxed at a lower rate (for 2010, this rate is either 0% or 15%, depending on the investor's tax bracket).
  
  

Less Capital Gains Taxation for Fund Holders

• When an investor sells shares in an ETF, this typically does not trigger sales of the stocks that compose the underlying index. Instead, the ETF shares are transferred directly to a buyer. Thus, the sale does not cause remaining fund holders to incur capital gains tax.
  
  By contrast, a sale of shares in a mutual fund requires the fund company to sell shares in the underlying stocks in order to pay the investor who is selling. This may result in capital gains distributions to investors who continue to hold the fund.
  
  

Ability to Time Gains and Losses

• As with any equities investment, selling an ETF will result in capital gains or losses for the seller. However, the seller can control the timing of the sale. Thus, ETFs provide investors the opportunity to decrease taxable income over their lifetime by realizing capital gains in years when their income is low, or by offsetting taxable income with capital losses in years when their income is high.
  
  Mutual funds also have this feature, but an individual investor cannot control sales of shares that may cause capital gains or losses for remaining fund holders.
  
  

Control of Short-Term Capital Gains

• A related point is that ETF investors can control whether or not they incur short-term capital gains, which are taxed at a higher rate than long-term gains, by simply holding shares for more than one year before selling. Mutual fund investors cannot prevent short-term sales by other investors in the fund, nor can they control changes in the fund's portfolio that may trigger short-term capital gains.
  
  

Low Turnover

• Because sales of stock may lead to realized capital gains, trading activity in a portfolio ("turnover") leads to tax-inefficiency. ETFs have very low turnover since they track fixed indexes and since sales of ETF shares do not trigger sales of stock by the fund company. This is true even in comparison to index mutual funds, which do not have the latter feature. It is especially the case relative to actively managed funds, which may have very high rates of turnover as a result of managers making portfolio changes.
  
  

In-Kind Redemptions

• Only investors with very large portfolios ("authorized participants") may trade directly with an ETF company. If an authorized participant decides to sell shares of an ETF to the fund company, the fund company can satisfy this redemption with stocks instead of cash. An ETF manager can use this type of in-kind redemption to unload the stock shares with the largest unrealized capital gains, which reduces the likelihood that an ETF will distribute capital gains to shareholders.
  
  

Demonstrated Tax-Efficiency

• In theory, it is possible for an ETF to be less tax-efficient than a similar mutual fund. However, this is very seldom the case in reality. Investment research firm Morningstar found that, in six of nine categories of domestic-stock funds, the average ETF had a lower tax-cost ratio than the average mutual fund. In those categories where ETFs were less tax-efficient than mutual funds, the reason for this appears to have been that ETFs had more income to distribute to investors as a result of their much lower expense ratios.