The lower costs associated with ETFs are the result of:
- Reduced fund administration costs.
When a cost can be passed on to another entity, such as the brokerage firm holding a customer’s ETFs in one of their accounts, a client service-related expense such as this helps keep costs down at the fund level.
- Reduced administrative, service and record keeping costs.
Since it is the brokerage firm’s responsibility to issue monthly statements, annual tax reports, quarterly reports and 1099s to its clients, ETF companies benefit from the lower overhead—and part of that savings is passed on to individual investors in the form of lower fund expenses.
- Absence of redemption fees.
Shareholders in ETFs avoid the short-term redemption fees that are charged on some other managed funds.
Tax consequences
ETFs are structured for tax efficiency. With regard to capital gains taxes, they tend to be lower than other managed funds since trading/turnover within the ETF itself is relatively low. Additionally, investors only realize any potential capital gains when they sell the ETF itself.
Where dividends are concerned, the tax situation differs depending on whether the dividend being issued by the ETF is considered qualified or unqualified. For a dividend to be considered qualified, the ETF needs to be held by an investor for at least 60 days prior to the dividend payout date. The tax rate for qualified dividends then varies between 5%–15%, depending on the investor’s income tax rate. For unqualified dividends, investors are simply taxed at their current income tax rate.