This Legal Way To Dodge Taxes Is Working Again This Year

An easy way to pay no tax — or indefinitely avoiding paying them on investments like the S&P 500 — is working again this year. How? Simply holding ETFs versus mutual funds.

Roughly 98% of stock ETFs offered by the largest providers are passing along absolutely no taxable capital gains again this year, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA. An in total, just 95% of all stock ETFs from all providers will trigger capital gains, says Morningstar.

Even some of the very largest ETFs, like SPDR S&P 500 ETF (SPY), iShares Core MSCI Emerging Markets ETF (IEMG) and Vanguard Total Stock Market ETF (VI), are all tax-free when it comes to capital gains distributions in 2021, Rosenbluth found.

And that’s actually quite an edge in a year like 2021.

The S&P 500 skyrocketed more than 20%. Regular mutual funds that sold during the year routinely passed along sizeable taxable gains to shareholders. Actively managed funds are distributing anywhere from 3% of assets up to 28% and triggering an unwelcome tax hit, says Ben Johnson, director of ETF research at Morningstar. Those gains face maximum capital gains rates of 20%, even for assets held for more than a year.

“We think ETF-focused advisors and investors will have fewer surprises at year end, and we expect people who mix ETFs and mutual funds together will be more inclined to shift toward strategies that incur fewer taxable events in 2021,” Rosenbluth said.

And that means shifting more money into ETFs.

Another Year For ETFs To Cut Taxes

Seeing no capital gains distributions from the big three stock ETF providers, BlackRock, State Street Global Advisors and Vanguard, is quite an accomplishment.

Just these three firms control more than three-quarters of the $7.2 billion invested in U.S. listed ETFs, Rosenbluth says. And the tax edge extends even to their bond ETFs, too. More than 90% of ETFs from these three companies are incurring no capital gains. That’s including bond ETFs, which tend to be less tax efficient as securities are sold when they mature.

ETFs Let You Pay No Tax On Capital Gains Again

It’s difficult to find ETFs paying sizeable taxable capital gains. Only 10 stock ETFs from the top providers are to trigger one this year, Rosenbluth says. And even the largest ETF distribution, is small by mutual fund standards.

The BlackRock U.S. Equity Factor Rotation ETF (DYNF) is seen generating a capital gains distribution of up to 4% of its value. It’s an actively managed ETF.

But even that’s a tiny tax event compared to what’s generated in capital gains by active mutual funds. The BlackRock Advantage Large Cap Core fund (MDLRX) is seen generating a whopping capital gains distribution of up to 17% of its value, Morningstar said.

Even Huge ETFs Like S&P 500 Dodge The Taxman

And don’t think it’s just small niche ETFs cleverly avoiding capital gains events. Even the behemoth ETFs are pulling it off.

The world’s largest ETF, the $436.9 billion in assets SPDR S&P 500 ETF (SPY), again, triggered no capital gains in 2021. And the same goes for the $207 billion-in-assets Invesco QQQ Trust (QQQ). Compare that with the 6% estimated capital gains distribution from the DFA US Large Company mutual fund (DFUSX). DFA uses factoring strategies to try to squeeze more performance from the indexes.

ETFs Don’t Complete Cut Taxes

Don’t assume, though, just because you’re buying an ETF that you’ll dodge the taxman entirely.

Bond ETFs, too, often trigger capital gains. The $84 billion-in-assets Vanguard Total Bond Market ETF (BND) is seen kicking off a 0.16% capital gains distribution in 2021, Morningstar says. Bond funds, whether ETFs or mutual funds, are more likely than stock funds to trigger taxable events. Roughly a quarter of taxable bond ETFs are triggering capital gains in 2021, Morningstar found.

And keep in mind, too, even many stock ETFs generate annual dividends, too. And those are taxable annually in taxable accounts whether incurred by ETFs, mutual funds or even individual stocks.

But ETFs continue to show why they are a key weapon in putting investors in control of taxes. “Unlike mutual funds, ETFs generally do not sell securities when investors redeem their shares,” Rosenbluth said. ETFs instead use an “in-kind mechanism that allows the fund to reduce the likelihood of capital gains.”

ETFs Mostly Cut Taxes

Few ETFs are likely to post taxable capital gains in 2021

Sources: Morningstar Direct