Index ETFs can be a very tax efficient way to build wealth. We discuss 5 ways they could help reduce tax.
Index funds are tax effective because they generally pursue a 'buy and hold' strategy as they seek to track their benchmark. Vanguard’s Australian Shares Index Fund for example, averaged less than 1% p.a. turnover in the three years to 31 December 2016.1
5 ways ETFs help reduce tax
- Low turnover
- Franking credits
- CGT discounts
- Listed funds
- Redemptions with market makers
1. Low turnover
Low turnover reduces distributed capital gains in a portfolio. This is because selling securities in a fund may cause a capital gains tax event. Because Index ETFs generally have low turnover, capital gain distributions are minimised. Reducing capital gains distributions means that investors delay the amount of tax they pay.
2. Franking credits
Franking credits are offered to prevent tax being paid twice on company profits; once at the company level and again when the investor receives the dividend income.
When an ETF receives dividends that include franking credits those dividends and the attached franking credits flow through to investors directly via the quarterly distributions.
Franking credits are received as 'tax paid' on dividends and when investors pay tax on the dividend they only pay the difference between the company tax rate and the investor’s marginal tax rate.
3. CGT discounts
Capital gains on shares held for longer than 12 months are eligible for capital gains discounting. Capital Gains on shares held for less than 12 months incur tax on the total amount.
The "buy and hold" strategy of an index ETF ensures low portfolio turnover and reduces the likelihood of realising capital gains, and when gains are realised it increases the likelihood of them being discounted capital gains.
Managed funds with a high portfolio turnover generally distribute higher capital gains for their investors, while the lower turnover in index ETFs takes advantage of the CGT discounting rules.
In addition, Vanguard optimise the calculation of the realised capital gains to ensure that the ETF takes full advantage of the discounting rules.
4. Listed funds
ETFs are a tax efficient investment vehicle because units are bought and sold on the secondary market. Market makers purchase new units from the fund and sell those units via the secondary market. When investors buy and sell ETF units the fund is not impacted until the market maker fully exhausts their inventory.
This is contrasted with unlisted managed funds where each application and redemption can cause buy and sell transactions in the fund, increasing the number and impact of tax events.
5. Redemptions with market makers
Specifically with ETFs, when market makers redeem ETF units any capital gains that are generated from this redemption are distributed directly to the market maker and do not impact ETF investors
Unlike unlisted managed funds, ETF investors do not receive any capital gains that are generated by the selling activity of other unitholders. Investors are not “buying into” large capital gains and do not see an increase in distributed capital gains when large investors leave the fund.
Index ETFs provide a great alternative to using direct shares as they provide investors with control and low cost, plus the tax effectiveness of index funds.
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1 Vanguard's Guide to Core-Satellite Investing, 2017