How to tap into the tax efficiency of ETFs

By Market Index
Thu 09 Jun 22, 6:09pm (AEDT)

Key Points

  • The tax effectiveness of ETFs is often overlooked
  • The unique structure of ETFs gives tax-savvy investors a chance to minimise capital gains distributions and allows for more assets to remain invested

Given that they can successfully avoid the costs associated with either financial advice or active fund managers and their costly administrative platforms, it’s hardly surprising that Australian investors have embraced exchange traded funds (ETFs).

In addition to not incurring entry/exit fees, ETFs also avoid paying upfront or trailing commissions to investment advisers.

While investors do pay normal brokerage fees when buying or selling an ETF, the management fee can be as low as 0.09% annually.

Ease of access and lower fees aside, its cheap underlying exposure to the performance of an index within a variety of asset classes, sectors and countries that typically attracts investors to ETFs.

ETFs V managed funds

But beyond their diversification, what’s often overlooked is the overall tax efficiency of ETFs relative to managed funds.

It’s also the distributable income, and franking credits on top of their tax-efficiency that make ETFs a welcomed addition to any share portfolio.

Unbeknown to a lot of investors, the machinations that go into working out their share of the tax liability - that’s been generated by an actively managed fund - can often lead to a nasty surprise for those who get in just before the end of the financial year (ending 30 June).

Given that many investors become singularly focused on the gross performance return, these after-tax return considerations, all too often, only surface once it’s too late to avoid them.

While it’s not uncommon for investors in actively managed funds to incur a tax bill disproportionate to the return on their investment (ROI), those in ETFs can avoid these sorts of shocks.

Market maker

While lower portfolio turnover reduces the potential for capital gains distributions, most of ETFs tax effectiveness over managed funds is due to the role of market makers.

Unlike unlisted managed funds, when investors sell ETF units the fund isn’t required to sell shares out of the portfolios, hence avoiding exposure to large capital gains tax (CGT) liabilities.

There are also rare cases - when an unlisted managed fund has had a large investor redeem from the fund - that can leave remaining investors to cop an enormous capital gains tax liability as a consequence of their exit.

Disastrous outcomes can’t eventuate

The market maker mechanism for ETFs means these disastrous outcomes can’t eventuate.

Thankfully, when a market maker – a role typically assumed by a professional trading company – finds there’s more of a surplus of inventory than it needs, it simply redeems the excess.

By taking the capital gains generated by the sale of shares out of the portfolio, the market marker, in the ETF scenario, is effectively protecting ordinary investors from the associated tax liability.

In other words, the decision by one ETF investor has no consequential impact on other (ETF) investors, and capital gains distributions are kept low.

It’s this unique structure of ETFs that gives tax-savvy investors a chance to minimise capital gains distributions and allows for more assets to remain invested, hence increasing the growth potential of the investment.

Tax-free distributions

Remember, under the CGT discount rules, certain tax breaks are also available to ETF investors.

Depending on an individual’s tax situation, a percentage of the distributions received as a realised gain may be tax free, with ETF investors potentially eligible to receive up to half of their realised gains tax free.

Included within the growing range of ETFs available to Australian investors on the ASX are equity income ETFs - paying out distributions and any associated franking credits – which should appeal to those searching for fixed income certainty.

Avoiding double taxation

Income investors can consciously target portfolios that, in addition to being tax-effective, also include fully franked dividends, which unlike other countries globally, do not incur double taxation.

With Australian corporate taxes having already been paid on dividend distributions, investors don’t need to pay those taxes again at the personal level.

The corporate taxes paid are attributed, or imputed, to the Australian investor through tax credits (AKA franking credits).

Franking credits can also be used to reduce an investor’s total tax liability to account for the taxes on dividends already paid by companies.

For individuals or complying superannuation entities, any excess franking credits can also be refunded at the end of the year if the investor’s tax liability is less than the amount of the franking credits.

That’s because any dividends investors receive will only be taxed at their respective marginal tax rates.

Admittedly, given that not all ETFs seek to deliver distributions with 100% franking credits, the onus is on you to check before investing.

Written By

Market Index

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