The New Retirement Funds: Exchange-Traded Funds

At the time of writing, exchange-traded fund assets in the United States have smashed through $1 trillion, achieving 1500% growth in assets in just one decade. This extreme growth rate shows how exchange-traded funds or ETFs will play a very important role in retirement planning and eventually replace mutual funds as the investment of choice for many future retirees.

One of the biggest attractions of exchange-traded funds is their low annual fees. Unlike mutual funds, which frequently come with annual expense ratios topping 100 basis points, along with front or rear-end sales loads, exchange-traded funds only rarely top 100 basis points. Instead, most ETFs can be enjoyed for less than half a percentage point, or fifty basis points.

This difference in annual expense ratios may seem small to some, but over the course of time, exchange-traded funds are far more likely to outperform the same index mutual fund. For the sake of demonstration, let's assume that an investor put $20,000 in an index that achieved annual returns of nine percent for 30 years. The mutual fund version of this popular index charges .70% annually, while the exchange-traded fund charges .25 percent.

At the end of the example period, the mutual fund balance would have grown to a respectable $218,717. The same amount invested in the above ETF, however, would have grown to $247,670 for a difference of $28,953. That's a big difference. If one were to convert their retirement investment to an annuity right there on the spot, the exchange-traded fund investor would take home an additional $120 per month in retirement income than would the mutual fund investor.

ETFs

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Have you ever opened a mutual fund statement to find that while the market was down and your funds lost value, that you actually owe capital gains tax? During the boom and bust cycle of the financial markets, it is entirely possible that even while the full value of a single mutual fund declines, the investor is liable for capital gains taxes on winning stocks that were sold by fund management!

Most commonly, this happens during the largest declines following the largest advances, and it puts a bad taste in many investors’ mouths. Thanks to the tax classification of exchange-traded funds, though, investors can shield themselves from capital gains until they're ready to cash in – not when the management is ready to do so for them.

The reason ETFs maintain this tax advantage is unknown by many investors, and admittedly there is very little difference in this regard between an exchange-traded fund and a mutual fund. A loophole exists that allows exchange-traded funds to be considered what is known as an “in-kind” trade. Thus, when stocks are exchanged for assets in an exchange-traded fund, the capital gains tax is not triggered. Mutual funds, however, have to trade stocks for cash and then for other stocks, which does require the realization of capital gains.

This small difference in tax and regulatory codes can add up to very large tax advantages. For one, investments into an exchange-traded fund practically grow tax free until the entire exchange-traded fund is sold. Thus, if one were to purchase $5,000 of a popular exchange-traded fund and hold it for ten years, taxes would be levied only at the time of sale. With a mutual fund, however, the investor would be liable for gains on every stock bought or sold in that ten year period.

Keep in mind, however, that dividend disbursements from an exchange-traded fund are taxed just like any other. It is minute changes in the overall portfolio as a result of an active manager's transactions that do not incur any taxing.

Final Tax Advantage


One of the most popular exchange-traded funds in history is the SPDR Gold Shares ETF(GLD). Through this fund, investors can essentially purchase a piece of gold in a vault, and for each share, own roughly a tenth of an ounce of gold bullion. By any standard, this fund should be relatively boring. Why would this fund be so popular?

This fund is so remarkably popular due to its obscene tax advantage. Unlike other investments, gold and silver bullion are considered to be collectibles, which means any profit or loss is treated like income and taxed at the investor’s income rate, not the capital gains rate. However, the IRS has decided that if an investor purchases gold bullion through an ETF trust like GLD through an individual retirement account, the gains are taxed just like any other capital gain.

Those who are interested in gold, but not interested in purchasing it through an IRA, have other options. While GLD is treated like income outside of an
IRA, the exchange-traded fund GDX owns gold miner companies, and it tends to rise and fall with gold. Thus, an investor could purchase the GDX ETF and take advantage of long term capital gains rates of 15%, versus much higher income rates.

The Dominance of Mutual Funds is Over


The days of the mutual fund are long over for investors, and it will be only a matter of time before exchange-traded funds lead the product list for most assets. Besides their tax advantage, exchange-traded funds have a cost advantage that comes from the sheer amount of competition in the industry.

While most retirement accounts through an employer offer only a very limited selection, investors who can reach into the stock market can access any exchange-traded fund at any time. As a result, fund companies are aggressively cutting costs, competing basis point by basis point with other firms for investment dollars. Mutual fund companies, however, are relying on their monopoly of retirement savings to keep prices high.

If you haven't already, explore possibilities to convert your retirement savings to an exchange-traded fund portfolio. Doing so will save you tens of thousands over the life of your portfolio in annual expense ratios and even more in taxation. For many, the switch is simple, and a growing minority of employee-sponsored retirement plans offers a brokerage window directly to the stock market, on which 900 different ETFs are traded.
Tim Ord
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