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Why have taxes on ETF investments historically run lower than on mutual fund investments?
AETFs are exempt from the federal capital gains tax
BCertain ETFs redeem proceeds in kind, not by selling
CETF dividends are exempt from federal income tax
DETF investors hold their shares only in 401(k) plans
Answer & Solution
Correct answer: B. Certain ETFs redeem proceeds in kind, not by selling
1. A fund that must raise cash to meet redemptions sells portfolio securities, which can realise taxable capital gains.
2. Those gains are then passed through to the remaining shareholders as distributions.
3. Certain ETFs avoid that step by redeeming in kind: they deliver specified portfolio securities to Authorized Participants redeeming creation units.
4. Because no sale takes place, fewer taxable gains are realised, and taxes on ETF investments have historically been lower.
5. No exemption from capital gains tax or from income tax on dividends exists for ETFs.
6. The advantage disappears where the investment sits inside a tax-advantaged account such as an IRA or a 401(k).
_Source: US SEC Office of Investor Education and Advocacy, "Mutual Funds and ETFs: A Guide for Investors", section Common Features of Mutual Funds and ETFs_
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