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Archive for Sunday, February 26, 2006

Exchange-traded funds can ease tax bite

February 26, 2006

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Doing your taxes this weekend? Me neither, but I am starting to feel guilty about it.

I'm procrastinating because I'm one of the millions of mutual-fund investors to be hit with a nasty tax bill this year, thanks to the rebound in capital gains distributions in 2005.

These payouts hit an estimated $125 billion in 2005, up from $55 billion the year before, according to the Investment Company Institute.

The year-end payments represent net profits on stocks or other holdings that a fund's manager sold during the year. Unless your fund is held in a tax-favored account such as an IRA or 401(k), the distributions are taxable capital gains - even if you automatically reinvest the money.

Fortunately, there are a number of strategies for avoiding or minimizing this problem, and fresh data show that one of the newest techniques - investing in exchange-traded funds instead of traditional mutual funds - can be quite effective.

ETFs are like mutual funds except that they are traded on the stock market, like stocks.

When mutual fund investors redeem shares, the fund company must sell some of the fund's holdings to generate cash owed those investors. If the holdings are sold for more than they'd originally cost, that profit winds up as a capital gains distribution.

ETF shares are not redeemed in this way - they are sold to other investors. That means the ETF issuer doesn't have to sell stocks to generate cash for redemptions, so there are no net gains to be distributed.

In addition, ETFs use an index-style of investing that tends to be quite tax-efficient. Instead of constantly changing their holdings in pursuit of the next hot stock, as actively managed funds do, they simply buy and hold stocks in an underlying market barometer such as the Standard & Poor's 500, the Nasdaq 100 or the Dow Jones Industrial Average. Thus there is little selling to cause distributions.

In general, funds with high turnover - those that change holdings often - generate bigger tax bills.

Jeff Brown is a business columnist for The Philadelphia Inquirer.

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