How To Legally Dodge Biden’s Capital Gains Tax In Your Portfolio

President Joe Biden’s proposal to nearly double the capital gains tax rate to 39.6% is unnerving investors. But there’s a legal way to delay — if not dodge — the tax hit: ETFs.

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Exchange traded funds’ unique structure largely shields them from capital gains taxes on annual distributions. Thanks to how ETFs buy and sell securities inside of tradable baskets, there’s almost never taxable capital gains distributions during the year. Mutual funds routinely pay investors capital gains distributions late in the year, which are immediately taxable when held in taxable accounts.

Proposed hikes in capital gains aren’t likely to affect most people. Taxpayers with annual incomes over $1 million are the target. And if you sell an ETF, as with any stock, the gain is still a taxable event. But the threat of rising capital gain tax rates is putting ETFs’ tax efficiency over mutual funds top of mind.

“Rightly or wrongly, investors and their advisors will become more tax-conscious,” said Lara Crigger, managing editor of ETFTrends.com. “This will encourage investors to take a closer look at ETFs, which are far more tax efficient than mutual funds for most contexts.”

ETF Tax Efficiency Shines With Capital Gains Tax

ETFs are usually more tax efficient than mutual funds, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA.

Why? ETFs’ unique “in-kind mechanism” allows them to avoid incurring capital gains during the year. ETFs don’t usually trigger a capital gains tax event for those who still own the ETF shares. Additionally, most stock ETFs are based on indexes, which do not buy or sell securities very often. Rosenbluth found that large U.S. stock ETFs usually trade just 4% of their positions annually.

That means only three out of nearly 600 stock ETFs from Blackrock’s iShares, Invesco, Charles Schwab, State Street Global Advisors and Vanguard passed along any capital gains to shareholders in 2020, Rosenbluth found.

In contrast, mutual funds routinely shuffle 20% of their positions or more annually. That can generate taxable capital gains that must be passed on to the funds’ owners each year. And more important, mutual funds facing redemptions must sell positions to cash out investors who redeem. This can gin up taxable capital gains distributions for the remaining mutual fund holders.

Rosenbluth found 37 of T. Rowe Price’s 39 domestic stock mutual funds passed along a capital gain to investors in 2020. That includes T. Rowe Price New Horizons (PRNHX), which distributed 9.2% of its net asset value to investors. The highest capital gains distribution among ETFs was iShares Evolved U.S. Innovative Healthcare (IEIH), at just 1.7% of its value.

You don’t pay a capital gains tax on individual stocks until you sell like ETFs, either. But it’s easier to hold on to a diversified ETF for a long time than an individual stock.

ETFs Don’t Avoid All Capital Gains Tax

But it’s important to note that ETFs aren’t completely immune from capital gains taxes, Crigger says. If you sell winning ETFs, you’ll still likely owe capital gains tax on the gain. You decide the timing of when you incur ETF capital gains, though. With mutual funds, you don’t control annual distributions.

ETFs have another edge here, too. If you never sell ETFs and donate them at death to your family or charity, you can avoid capital gains taxes altogether, says Dave Nadig, director of research at ETFTrends.com. That’s because the cost basis of the ETF is “stepped up” to the value upon your death. So when the beneficiary sells the ETF, there’s no taxable event.

Biden, though, is proposing to do away with this stepped-up basis rule for any gains over $1 million for individuals and $2.5 million per couple with real estate exemptions.

Capital Gains Tax: Reality Vs. Fear

The threat of higher capital gains tax rates is only heating up a shift to ETFs that’s been going on for years. Do you know how to find top ETFs?

Money flowed into stock ETFs in 20 of the past 25 months through the end of January, Nadig says. Money flowed out of stock mutual funds in 24 of those 25 months. And this year through April 14, $117 billion flowed out of stock mutual funds, Rosenbluth says. At the same time, more than $229 billion in new ETF issuance has taken place.

It’s true that most mutual funds are held in tax-deferred retirement accounts. And dividends on both ETFs and mutual funds are taxable when paid. But ETFs’ tax edge is appealing, whether investors wind up paying the higher capital gains tax or not, Rosenbluth says.

Biden’s proposal for a capital gains tax rate hike “will likely impact a small universe of investors,” Rosenbluth said. But Crigger adds: “Biden’s tax proposal, in whatever form it takes, even if it never comes to fruition at all, will be a net gain for ETF assets. When people are motivated to take a closer look at the tax impact of their investments, they almost always gravitate toward ETFs.”

ETFs’ Tax Shield

None of the largest ETFs paid capital gains distributions in 2020

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