Exchange-traded funds (ETFs) might be ideal for taxable accounts because they help investors avoid a trap into which mutual fund investors may fall. Mutual funds must distribute any net trading gains to their investors. If those mutual funds are held in a taxable account, investors may wind up a given year owing large amounts of tax even if they chose to reinvest those capital gain distributions.
ETFs, though, are structured to minimize such unwanted distributions to investors. For example, Barclays Global Investors offers more than 80 iShares ETFs. Last year, none of those ETFs made year-end capital gains distributions to investors. This ETF advantage is most helpful if the shares are held in a taxable account, where any capital gain distributions would be subject to income tax each year.
Not only do ETFs offer more advantages in taxable accounts, they’re also better suited to investors who can make large purchases. Brokerage fees can reduce the benefits of ETFs for small investors. Because ETFs are traded like stocks, you must pay a commission each time you buy and sell. Even a modest commission paid to a discount broker can take a chunk out of your potential return from a small order. Therefore, you may prefer to wait until you have several thousand dollars to invest, rather than making a series of smaller purchases.
