Are ETFs Tax-efficient?

Exchange-Traded Funds (ETFs) can be your reliable option in various investments. ETFs not only simplify investing and offer diversity but also bring the advantage of tax efficiency. Whether you’re just starting or have experience, ETFs can be your allies in building your wealth while keeping your taxes low. In this article, learn how ETFs are tax-efficient.

What Is an ETF and How Does It Work?

ETFs are investment funds that track the performance of specific indexes, such as BSE Sensex or Nifty 50. When you purchase ETF shares or units, you’re investing in a portfolio that mirrors the returns of its underlying index. Unlike other index funds, ETFs don’t aim to outperform their respective indexes; instead, they strive to replicate the market’s performance. They are passively managed. 

ETFs are traded on stock exchanges like a common stock, where their prices fluctuate throughout the day based on the underlying asset values. They are known for their high liquidity and cost-efficiency compared to traditional mutual funds, making them an attractive choice for individual investors.

ETFs are taxed based on their categories. Let’s get a sense of ETF categories to understand how they are taxed.

Categories of ETF

ETFs are of various types based on their characteristics, which include:

1. Equity ETFs: ETFs that track the performance of stock indexes or a set of stocks from a particular industry or business are known as equity ETFs. The goal is to invest in equities that will track the performance of the benchmark indices like BSE S&P 500, Nifty 50, etc. They also track sectors like Nifty FMCG, Nifty IT, etc.
2. Fixed-income ETFs: As the name suggests, these ETFs invest in fixed-income securities like bonds, debts, etc. These can be preferred by risk-averse investors as they are not market-linked.
3. Commodity ETFs: These ETFs track the prices of different commodities, such as precious metals, agricultural goods and natural resources. Gold ETFs invest in gold bullion, allowing investors to include gold in their portfolios without making a direct investment in physical gold.
4. International ETFs: Some exchange-traded funds are based on foreign stock indices. They provide investors with access to international markets and the opportunity to expand those countries’ economies.

Taxation on ETFs

Now that you know the categories of ETFs, let’s understand how they are taxed. You can earn income on ETFs in two ways – through capital gains and dividends:

1. Tax on dividends: As ETFs are a basket of securities, you may get dividends from each security (if applicable). For instance, if you invest in an Equity ETF holding 50 different stocks, the fund will receive dividends from each of those 50 companies. Some ETF providers give these dividends to investors, while others reinvest them into the ETF to potentially offer higher overall returns. These dividends are typically taxed at the applicable income tax rates of the investor. 
2. Tax on capital gains: In the case of capital gains on ETFs, the taxation depends on the ETF category.

• Equity ETFs are taxed similarly to equity mutual funds; gains of more than ₹1 lakh and held for over a year are taxed at 10%. On the other hand, equity ETFs held for less than a year are taxed at 15%. 
• International or debt ETFs are considered short-term capital assets irrespective of the holding period since the Finance Bill as of April 1, 2023, and are taxed at the prevailing income tax slab rates.
• Gold ETFs that are bought before March 31, 2023, are taxed as per the holding period, i.e., the gains from ETFs held for more than 36 months are considered long-term and taxed at 20% with an indexation benefit. If the holding period is less than 36 months, they are taxed per the investor’s income tax slab. However, the gold ETFs that are bought after March 31, 2023, are considered short-term capital assets irrespective of the holding period and are taxed at the prevailing income tax slab rates.

Are ETFs Tax Efficient?

• Comparatively low returns: ETFs track stock market benchmarks precisely and don’t actively try to beat them. This usually results in relatively modest returns compared to some other types of mutual funds, which can also mean lower tax liability.
• Setting off losses: ETFs are traded on the stock exchange. There can be instances where investors sell their ETFs at a lower rate than they bought them for, resulting in capital losses. These losses can help reduce the tax bill. Here’s how it works:

– Capital losses can offset capital gains.

– Long-term losses can offset long-term gains.

– Short-term losses can offset both short-term and long-term gains.

– If you have more losses than gains, you can carry forward the losses for up to eight financial years to offset future gains.

• Creation units: While less common in emerging markets like India, there can be instances where fund managers sometimes use creation units to manage cash inflows into ETFs without causing capital gains for investors.

A creation unit is a set number of ETF units exchanged for a portfolio of index-linked shares, known as the ‘Portfolio Deposit’ and a cash component. For example, to acquire 10,000 ETF units, an investor must deposit the predetermined portfolio and the cash component. In return for these assets, the investor receives 10,000 units. This “in-kind” exchange of the portfolio for units is a special characteristic of ETFs. The creation of ETF units is determined for every ETF unit and is available on the AMC portal. 

Conclusion

ETFs are designed in a way to offer modest returns while maintaining lower operational costs. They can be tax-efficient in your investment portfolio while offering modest returns through stock market exposure and diversification. To invest in ETFs, you need to have a Demat account. Open a demat account for free on Angel One. 

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