Capital Gains Need to be Focus Before Year End

With the Bush tax cuts on capital gains and dividends due to expire December 31, ETF investors need to evaluate what tax moves to make before the year ends, says the ETF Team at Charles Schwab.

“ETF investors need to focus on capital gains,” Michael Iachini, the managing director of ETF Research at Charles Schwab Investment Advisory during a conference call. Because that tax rate on capital gains may rise next year, “If you have ETFs that you’ve owned for many years, especially since the bottom of market from 2009, you may have big gains. If you have large unrealized capital gains you may want to take them in 2012.”

While ETFs have a reputation for being tax efficient, that efficiency relates to the securities within the fund. Mutual funds incur capital gains every time the fund sells securities for a profit inside the fund. While ETFs can realize capital gains, they rarely do, especially in equity ETFs, because of how the ETF is structured. However, individual investors still incur capital gains in their personal portfolio accounts anytime they sell a mutual fund or ETF for a profit.

Another strategy investors use to lower their capital gains taxes is to sell other investments at a loss. This is called tax-loss harvesting because investors can offset capital gains with a similar loss of capital.  However, a big concern with tax-loss harvesting is investors need to avoid the wash sales rule. If you sell a security for a taxable loss and you buy a substantially identical security to the one you sold within 30 days it’s called a wash sale and you don’t get to count the loss.

“The most important thing clients need to be aware of is that not all ETFs are tax efficient,” said Eric Pollackov, Schwab’s managing director of ETFs.  “There are many ETFs that don’t allow the in-kind redemption process [where shares are traded for other shares] and they have to use cash.” These exchange-traded products track commodities and currencies and often hold futures contracts or physical commodities.”

Pollackov said Schwab has yet to pay capital gains in any of our ETFs since their inception. “This shows the skill of our team,” he said. “We try our best to have each ETF track its underlying index, but also make sure that it isn’t paying capital gains at the end of the year.” Schwab ETFs hold only equities and bonds. None hold commodities, futures or currencies.

Pollackov also noted that Schwab’s original eight ETFs hit a milestone recently by passing their third birthday. This is significant because most investors and advisors refuse to look at a fund before it has a three-year track record. This period of time give investors a good idea how a fund and its manager perform in a variety of markets circumstances. Not only does the third birthday show the products are well established and are probably here to stay, but many rating agencies, such as Morningstar, won’t rate a fund until it’s three years old.

He also suggested investors check out Schwab’s new educational research website at


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