ETF Tax Primer

When an investor wants to purchase or sell shares of their mutual fund or ETF, they typically do so via a brokerage or intermediary firm, though ETFs can also be purchased and sold on an exchange.

Although these two scenarios sound very similar, an ETF can help give an investor more optionality over their capital gains. For example, when you own a mutual fund or an ETF, you have the chance of realizing additional gains because when the fund sells securities in its portfolio that have gains (i.e. they’ve made money on those purchases), they created a taxable event.

For instance, if a mutual fund buys shares of the following securities:

A short while later, the mutual fund sells its shares of the same securities:

The mutual fund now has $40,000 in capital gains. The fund can offset these gains by generating an equivalent notional amount of losses (i.e., selling securities for a lower price than originally purchased). Otherwise, the gains will be distributed across the mutual fund owners.

That said, ETFs can more easily leverage a third option for capital gains with the help of a Nixon-era tax law.

In 1969, Congress passed legislation (Tax Reform Act of 1969) that mutual funds can hand over stocks with embedded gains to withdrawing investors without triggering a taxable event. However, putting this into practice with a mutual fund is a bit more difficult than in the ETF vehicle, as the mutual fund would need to raise a notional equivalent dollar amount, which would mean they would need to sell a proportionate amount of shares.

On the other hand, this trade/transaction for an ETF features a slight modification that occurs on a relatively frequent basis.

Importantly, the development of an authorized participant (AP), or a qualified organization that has the right to create and redeem shares of an ETF, allows for an ETF to remove securities with embedded gains out in a nontaxable way via the creation and redemption pathways found here.

For example, if the ETF wants to sell securities AAAA, BBBB, CCCC, and DDDD, which have gains of $40,000 across the entire assets under management of the ETF, the ETF fund management team can contact an AP of the ETF and ask them to submit a creation of appropriate size.

The transaction would typically look like this:

AP #1 submits a creation on the basket in the ETF for $40,000. After the purchase, the underlying securities recognize gains. A few days later, the same AP submits a redemption order for the same $40,000 worth of ETFs. Instead of the initial basket, this time the AP receives a basket with 1,000 shares of AAAA, 1,000 shares of BBBB, 1,000 shares of CCCC, and 1,000 shares of DDDD.

In taking this approach, the names that the ETF fund manager wanted to sell are removed from the ETF' portfolio in a nontaxable manner and no gains are to be distributed to any of the ETF shareholders.

Unlike with many ETFs, the lack of the AP in mutual fund transactions means that it would cost a lot of time and money to continuously facilitate transactions like this in the mutual fund wrapper.

Harbor Capital Advisors

Harbor Capital Advisors is an asset manager known for curating an intentionally select suite of active ETFs from boutique managers. Advisors looking for distinct and differentiated investment options for their clients' portfolios often connect with our passionate obsession to find what we believe to be the best - bold solutions that have the potential to produce compelling, risk-adjusted returns.

For more information, visit www.harborcapital.com

Important Information

Investors should carefully consider the investment objectives, risks, charges and expenses of a Harbor fund before investing. To obtain a summary prospectus or prospectus for this and other information, visit harborcapital.com or call 800-422-1050. Read it carefully before investing.

Investing involves risk, principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. Shares are bought and sold at market price not net asset value (NAV). Market price returns are based upon the closing composite market price and do not represent the returns you would receive if you traded shares at other times.

ETFs are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are generally minimized for the holder of the ETF. An ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying portfolio. However, capital gains tax may be incurred by the investor after the ETF is sold.

Shares of ETFs may be bought and sold throughout the day on the exchange through any brokerage account. Shares are not individually redeemable from an ETF, however, shares may be redeemed directly from an ETF by Authorized Participants, in very large creation/redemption units.

This material is not legal, tax or accounting advice. Please consult with a qualified professional for this type of advice.

Foreside Fund Services, LLC is the Distributor of the Harbor ETFs.

Harbor Capital Advisors, Inc.

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