An Insight into the Intricacies of Investing in Mutual Funds and ETFs

-Supriya Bellur

Let us begin by talking about ETFs. What are ETFs? Well, Exchange Traded Funds are passively managed securities that are assessed after periods of time (say quarters or half-years for instance). Due to their management style, they attract a certain, earmarked return. Even though the price of ETFs change often, they stick close to the value of their index.

Mutual funds on the other hand are investments funds that are created by gathering money from investors to purchase securities. Mutual funds are actively traded by investors who buy in or sell their securities and attract a higher management fee.

Looking into taxing these financial instruments, an advantage may become evident. Before we delve into this, it is pertinent to talk about capital gain tax.

Capital gains are the profits that one earns when an asset is sold. Capital gains may be long term or short term. Taxes on these profits are paid to the government as its “share”. These taxes are unpredictable as rates can vary over a period of time. People who earn short term capital gains are taxed according to their income bracket. And while the same holds true for long term gains, it is very likely that the rates are more conducive and favourable.

Mutual funds managers purchase securities when people buy into the fund and sell the same to pay off a person selling owned shares. This can be a very volatile process and investors do not have the power to determine which shares are sold and therefore have no control over the taxes payable.

ETFs are traded between investors as a manager does not exist and they are not traded very often. According to the IRS (Internal Revenue Service) ETFs cannot be taxed unless the entire unit is sold. Therefore, taxes do not apply when you are holding shares. As investors have personal control over their shares they can decide when they want to pay their taxes by selling their ETFs.

Now, coming to the concept of dividends. Dividends are not exempt from taxes. There are two kinds of dividends, ordinary and qualified. To begin with, Ordinary dividend is a systematic payment made by a company, out of its earnings, to its shareholders instead of reinvesting in the firm. They are taxed at normal income rates. Qualified dividends are like long term capital gains and receive preferential tax treatment. The tax rates may range from 0%-23.8% But in order to claim this kind of dividend both the ETF investor and manager need to prove that it has been held for more than 60 days. Understandably, this is complicated to do. As a result dividends for Mutual Funds do not receive advantageous treatment all the time.

With the objective of reducing inequality, Joe Biden’s proposal to raise the upper limit of the long-term capital gains from 20% to 39.6% will result in well-off investors (individuals earning more than 1 million) looking for different ways to alleviate the tax effect. Shifting from Mutual Funds to ETFs may be one such option for reasons described above.

Tax plays a predominant role in a plethora of investment decisions. However, it is important to understand that tax alone does not determine investment decisions and several other factors are involved. Making an investment is a huge step and requires meticulous and systematic planning.