ETFs usually have lower fees and more options than traditional mutual funds, while offering more avenues of diversification, opportunity, and far superior tax-loss harvesting options. This is why I use ETFs and individual securities for my clients.
For most of the 20th century, traditional mutual funds were accepted by investors as the best investment products for building wealth and diversification. In 1993, a new kid on the block came in and changed the investment landscape forever. That’s when SPY, the SPDR S&P 500 ETF, was introduced to the world. Global investment in ETFs now totals nearly $10 trillion.
ETFs are typically more cost effective and tax efficient than their older sibling, mutual funds. The investments held inside both of these types of funds can be the exact same, but the tax adjusted returns can vary dramatically. Both funds can buy and sell securities throughout the year that create capital gains or losses within the fund. With mutual funds, those gains or losses are passed on to the investor in the calendar year that each individual security was sold. Typically, in December of each year, mutual fund owners will receive their capital gains or losses reports. These can sometimes be shocking. In the stock market selloff of 2022, the S&P 500 was down about 18%, yet many mutual fund owners were given large tax bills because investments within the fund were sold in the year 2022.
When it comes to ETFs, capital gains taxes are only paid when you sell the ETF. There are no yearly capital gains or losses, like with mutual funds. You will have capital gains when you sell your ETF, but you will have more options as to when you pay those taxes. You can also possibly find capital losses somewhere else that you can match those off with. If you hold onto these ETFs until you pass away, you will never have to pay that capital gains tax and your heirs will receive those funds at a stepped-up basis. Their new cost basis will be the value of the fund on the day that you died.
Tax-Loss Harvesting
| Ticker Symbol | Investment | Shares | Price Paid | Current Price | Value | Gain/Loss |
|---|---|---|---|---|---|---|
| SPY | S&P 500 ETF | 50 | 300 | 498 | $24,900 | $9,900 |
| AAPL | Apple Stock | 100 | 130 | 188 | $18,800 | $5,800 |
| T | AT&T Stock | 500 | 31 | 17 | $8,500 | $-7,000 |
| MSFT | Microsoft Stock | 50 | 200 | 414 | $20,700 | $10,700 |
| XLU | Utilities ETF | 200 | 73 | 60 | $12,000 | $-2,600 |
| Total | $84,900 | $16,800 |
Let’s say that you bought 5 different investments over the past several years. You may want to sell your SPY ETF, but you would have to pay capital gains taxes on $9,900. The long-term capital gains rate is 15%, that means that you’d have to pay $1,485 in taxes. Using a tax-loss harvesting method, you could also sell your AT&T and Utilities stocks that have losses of $7,000 and $2,600 respectively. You can subtract that $9,600 loss from your $9,900 gain. You now only have a gain of $300, and owe only $45 in capital gains taxes. ETFs allow for a much better opportunity of using tax-loss harvesting to improve your tax-adjusted returns.
| Investment | Gain/Loss | Potential Tax |
|---|---|---|
| SPY | $9,900 | $1,485 |
| T | $-7,000 | $-1,050 |
| XLU | $-2,600 | $-390 |
| Total | $300 | $45 |
In qualified accounts, such as 401ks and IRAs, the tax-loss harvesting effect is less important because you don’t pay capital gains taxes. You will have to pay ordinary income taxes on the money when you withdraw it from the account. You will also have to account for which gains are long-term and which are short-term. Short-term gains are taxed as ordinary income, but again, ETFs make for easier tax-loss harvesting.
