There's no question that exchange-traded funds—those bundles of equities, bonds or other assets that trade as a single stock—make investing considerably easier for many people. But during this year's tax season, investors may find that one of the biggest benefits of ETFs—tax efficiency—doesn't live up to the hype.
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The biggest problem, analysts say, involves ETFs that use derivatives, financial instruments that can be used to bet on future prices. Investors poured millions of dollars into derivative-using ETFs in 2010, as a way to either double-down on bets on certain areas of the market or, in many cases, speculate on commodity prices. But investors who own these ETFs in a taxable account will be hit with a tax bill every year—regardless of whether or not they've sold their shares. What's worse, 40 percent of any profits will be taxed at the short-term capital-gains rate, rather than at the lower long-term rate. Investors in commodity ETFs that don't use derivatives aren't safe from higher taxes either. When these ETFs are sold, profits are taxed at the ordinary income rate—up to a maximum of 28 percent. As far as the government is concerned, having a gold or any precious metals-backed exchange-traded product "is no different than owning Krugerrand coins," says Paul Justice, an ETF strategist at Morningstar.
Another potential tax headache: difficult paperwork. Investors in some types of ETFs might get a Schedule K-1, a partnership tax form, from the IRS. Many financial advisers say the K-1 is more complex than the Schedule D, the form people usually use to report capital gains on stocks. Drew Tignanelli, the president of Financial Consulate in Hunt Valley, Md., says ETF investors who receive a K-1 will probably have to pay a bit more to their accountants—but it's worth it. "If you file a K-1 form, you really have to know what you are doing," he says.
If avoiding big tax bills is a major concern, some analysts recommend that investors avoid commodity-related ETFs, since those are often the ones that create the hairiest tax issues. Keeping ETF trades to a minimum also can keep tax bills down. "Many ETFs are tax-efficient, but not for traders," says Justice. Even some industry players admit there are ETFs that can be, well, taxing. The ETF industry has overhyped the tax benefits, says Joel Dickson, a senior investment strategist at Vanguard, the third-largest player in the ETF market. Some popular ETFs are "inherently tax-inefficient," he says.
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