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A proposal by the Biden administration would remove the preferential tax considerations for long-term holders of stocks. In so doing, it will cause investors to favor active ETFs over traditional actively managed mutual funds.
The marginal tax rate for long-term capital gains (positions held more than one year) is 23.8%, including the Medicare surtax. Those proposals would bring the top rate to 43.4%, and no longer differentiate between long-term and short-term capital gains. This is a material change that impacts the way investors approach their wealth management.
Tax considerations will increasingly incentivize investors to allocate capital towards non-taxable and tax-deferred accounts, such as IRAs, and 401(k) or 403(b) plans. Taxable accounts would be exposed to these higher tax rates, where the benefits associated with the ETF structure are more pronounced.
For investors who allocate to actively managed mutual funds, a new option is quickly gaining traction: active ETFs. While active ETFs have been available since 2008, they’ve begun to gain popularity in the past five years. Active ETF assets have grown from $50 billion in 2015 to $100 billion in 2018, and over $200 billion in 2021. The number of active ETFs has doubled since 2018, per a recent Morningstar report.
Why are active ETFs potentially more tax efficient than active mutual funds?
Let’s compare the movement of cash between investors and the underlying funds in both an active ETF and mutual fund structure. In a mutual fund, new capital is sent directly to the fund, which the manager uses to purchase securities which are to be fund holdings. Each of these transactions come at a cost to all of the pooled investors in the fund, regardless of which particular investor(s) allocated new capital. More relevant from a tax perspective, when an investor in a mutual fund withdraws capital, the manager must sell securities to meet that redemption request. If those securities were held at a gain by the mutual fund, this may result in a taxable event for all investors.
