As we approach the end of 2015, it’s a good time to recall another one of the advantages of using ETFs rather than mutual funds. When investing in mutual funds close to year-end, it is important to consider when the mutual fund might pay out capital gains for the year.
The law requires that a mutual fund must pay out, at least once annually, all capital gains realized during the year. These capital gains are allocated each year, to the current mutual fund shareholders, on a pro rata basis. Most mutual funds pay capital gains in November or December.
Therefore, investors want to avoid large new mutual fund investments near the end of the year. Why? Year-end capital gains distributions can cause problems: Suppose an investor put $100,000 in a mutual fund late in November and that the mutual fund went down 5% by year end. Even though the investor has lost money he could still be allocated capital gains tax. For example, if he was allocated $5,000 in capital gains, and paid 20% capital gains tax, he could end up with a loss at year-end of $5,000 and still need to pay $1,000 in taxes! (That would really be adding insult to injury.)
ETFs on the other hand, don’t typically pay out capital gains at year end. Since ETFs only transact securities in-kind they don’t realize capital gains. Therefore, they don’t typically allocate capital gains to shareholders each year. Thus the better choice is to go with ETFs to avoid capital gains, as a result you will still be able to achieve the benefits that mutual funds offer through ETFs.
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