Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.
This bill is just in the trial balloon stage of consideration. It reportedly has support among mutual fund providers. Adoption (a long shot possibility?) would somewhat level the playing field between mutual funds and ETFs.
Good! I'm hoping that it passes. I am sick and tired of the (tax) advantages handed to those who already have, at the expense of those who struggle dad by day to get by. If all men are created equal then tax them equally and close, eliminate, or rubout all existing tax advantages.
More details from a WSJ article in Apple News, "Democratic Tax Proposal Takes Aim at ETFsBig money managers are bracing for a fight over Senate Finance Committee Chairman Ron Wyden’s proposal"
Senate Finance Committee Chairman Ron Wyden’s proposal aims to tax ETFs’ use of “in-kind” transactions that currently avoids triggering capital-gains taxes. With such in-kind transactions, ETFs—bundles of securities that trade on exchanges—transfer appreciated stock, bonds or other assets to Wall Street intermediaries instead of cash. By closing a decades-old tax regulation loophole, the proposal stands to eliminate one of the ETF industry’s key selling points: tax efficiency. This proposed change has spurred a rush to mobilize among the largest asset managers, some of whom have built their businesses around the ETF industry. “ETFs have become big capital gains deferral machines,” said Jeffrey Colon, a professor at Fordham University School of Law who has researched this topic. ETFs are able to avoid taxes with in-kind transactions thanks to a tax exemption intended for mutual funds, created long before ETFs existed. “The ability of these funds to do in-kind redemptions of appreciated property is being weaponized and used in a way that Congress surely couldn’t have intended,” he said. The impact of the proposal would largely fall on ETFs rather than mutual funds, which largely distribute assets to investors in cash.
This proposal does not affect ETFs used in tax-deferred accounts. We still have much to learn on the details of this proposal and how it affects our investment.
Passage of this bill would force taxable account investors to buy and hold onto individual stocks to continue to receive some of the advantages available through tax-deferred retirement accounts. That would uncomfortably alter the investing landscape for many taxable account ETF investors.
@davfor - If I understand what you are trying to say then I disagree with your statement above "Passage of this bill would force taxable account investors to buy and hold onto individual stocks to continue to receive some of the advantages available through tax-deferred retirement accounts. That would uncomfortably alter the investing landscape for many taxable account ETF investors."
Those taxable account ETF investors can sell shares of their ETF's and receive cash on which they'd pay their fair share of taxes 'rather' than receiving (from the article) "A proposal has been drafted to change the law eliminating exchange traded funds’ chief tax advantage in the US by levying taxes on in-kind redemptions."
The average Joe ends up paying the taxes either way because few, if any, are "authorized participants" while those who are already exceedingly rich can game the system.
"Only “authorized participants” – a form of institutional investor – may redeem shares directly from an ETF. These investors are also able to contribute securities to a fund in exchange for newly issued ETF shares. Retail investors, on the other hand, can only buy and sell ETF shares through a broker."
@Mark, I read the same article. I believe this applies to these authorized participants, not individuals, who don’t pay tax on sale of ETFs. Slick back-door practices.
If, in fact, the proposed legislation aims to levy CG taxes on the big traders and big financial firms that benefit from the tax loophole, I might favor it. OTOH, if the individual shareholder, “the little guy,” were to bear the burden of yearly CG taxes on fund distributions, I’d tend to think it was just another effort to shelter the truly wealthy to the disadvantage of the middle class. The recent changes in IRA distribution rules do not really affect the wealthy, who don’t rely on IRA investments to save for retirement. The rules do, however, shift a tax burden to the heirs of taxpayers who, in all likelihood, are of relatively modest means. The wealthy can pass on vast sums practically tax-free to their heirs. I’m old enough to remember the new tax rules governing IRAs the Reagan administration promulgated. Individual shareholders had to cough up big bucks for tax year, 1986, IIRC. Relative to my wealth, my two cents represent a lot, in case you were wondering…
I think folks interested in having an opinion re the proposed legislation should read the bill and not draw conclusions based on some reporting in the media, even financial media.
BTW, mutual funds can also avoid/minimize distributing capital gains under the current law if they are not lazy. (That is in addition to their ability to do in-kind redemptions.) You can read about it at Liberty Street Funds.
Vanguard individual investors will be affected according to WSJ:
"Vanguard Group declined to comment on the proposal, but said “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.” For the majority of its U.S. ETFs, Vanguard uses a unique structure in which the firm’s ETFs are share classes of mutual funds.
In these cases, Vanguard’s ETFs can transfer appreciated stocks out of the mutual fund they are tied to in exchanges that don’t incur tax consequences for investors. This means that taxation of in-kind trades would affect both Vanguard’s ETFs and mutual funds.
Executives at Vanguard over the years had questioned whether the favorable tax treatment of in-kind trades would last, said a person familiar with the matter."
@Sven - and again I'm of the opinion, but I have no evidence to support it, that the uber-rich individuals are connected in a way to play the same game that your average Joe can't.
But hey, anyone of modest means please try to sell an ETF that you hold using an in-kind redemption and let us know how it works out.
@Mark Thanks for your response to my comment. It has prompted a lively discussion of issues I had not considered. My rereading of the article and the excerpt from the WSJ article posted above both suggest the law would likely result in negative tax impacts for current ETF shareholders. Even if that is the case, it makes sense for Congress to consider it as a way to increase revenues. ETFs offer tax advantages over OEFs outside a tax-deferred account. Do all those tax advantages continue to make sense? There will always be a price to pay when tax laws change to increase revenues.
The article @Mark linked above clearly stated what “in-kind redemption”. The rich get other securities instead of cash. Thus that is not a taxable event. I would like to get the same treatment too with a few yachts and mansions.
There are other changes coming for high income individuals such as Roth conversion will be limited.
Regarding Roth conversion limits for high-earners, Congress chose to delay the limits for 10 years according to Ed Slott:
"In order to close so-called “backdoor” Roth IRA strategies, the bill eliminates Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation).
“This is similar to the old $100,000 income limitation for Roth conversions that existed before 2010, except now the income limits are increased to the $400,000/$450,000 levels,” Slott explained. “Oddly though, this proposal would not be effective for 10 years. The effective date says this would apply in years after Dec. 31, 2031.”
This change “would end Roth conversions for high-earners, but Congress still wants its conversion tax dollars. What to do?” Slott continued. “Maybe this delayed effective date shows us that Congress still needs this Roth conversion revenue so it can fill budget gaps, at least for the next 10 years. So, this provision is a non-issue for now.”
An oft heard refrain: I just want to make sure that the small investor isn't hurt. Coincidentally, the definition used for small investor turns out to include the speaker. Though it may sound like I'm picking on BenWP here, my observation is general. Even before reading details of the proposal, I was confident that the proposed change would fall primarily on wealthier investors.
First, because the truly little guy is insulated from capital gain taxation - until one's taxable income exceeds $40,400 (single) or $80,800 (joint), cap gains are taxed at 0%. Second, because (at least as of 2012) only 1/3 of households even had taxable investment accounts, and I think it's a safe bet that these are largely not lower income households. "It is immediately clear that household income has the strongest relationship with taxable account ownership."
The in-kind transaction loophole existed for all forms of businesses (corporations, funds, etc.) since 1935. Congress began narrowing it in 1969. It was little used until ETFs came along and exploited it. It has never made sense from a tax principle perspective - cap gains cannot simply go **poof**. Logically they should either accrue to the company (RIC) or if passed through, to the recipient.
Throughout the history of U.S. investment companies, in-kind distributions have been exempt from tax at the fund level. As Congress began to limit and finally prohibit in 1986 the tax-free distribution of appreciated property by corporations, it continued to specifically exempt open-end funds from this rule. There is scant discussion in the legislative history for the justification for this exemption or why closed-end funds were not also eligible. Perhaps the simplest explanation for the legislative silence is that when [the tax code was changed to narrow the exemption], in-kind distributions from open-end funds were rare.
As to the proposal, it is simplicity itself. Registered investment companies (OEFs and ETFs) are to be treated the same way as other companies. When they sell holdings, they are to recognize capital gains. Regardless of the form of the sale, i.e. regardless of whether they receive cash or fund shares in exchange for the securities they sell.
No more special cases. No special case because they're conducting an in-kind transaction. No special case because they're an OEF or ETF rather than a CEF.
ETFs would be expected to respond by selling their highest cost shares to the AP (authorized participant) rather than their lowest cost shares. At least if they cared about tax efficiency. That's the same method that OEFs use when raising cash to redeem shares.
Regarding Vanguard: Even before Vanguard started selling VIPERs (Vanguard Index Participation Receipts), their index funds tended to be the most tax efficient on the market. There were many years when their broad based index funds did not distribute cap gains. The proposed change should make Vanguard funds (and ETFs) look even better relative to their competition because of demonstrated skill in minimizing taxes.
Vanguard writes: “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.” Funds could always transact in-kind.
ETFs fundamentally rely upon this ability in order to keep market price close to NAV. The proposed change does not affect their ability to transact in-kind. OEFs sometimes rely upon this ability as well. It is reasonably well known that Sequoia not only reserves the right to redeem shares in kind, but states explicitly that it is likely to do so for redemptions above $250K. Investors benefit because funds are not forced to conduct fire sales to meet large redemptions.
Sequoia Prospectus: It is highly likely that the Fund will pay you in securities or partly in securities if you make a redemption request (or a series of redemptions) in an amount greater than $250,000.
The part of the text that pertains to ETFs, in its entirety is:
SEC. __17. RECOGNITION OF GAIN ON CERTAIN DISTRIBUTIONS BY REGULATED INVESTMENT COMPANIES. (a) IN GENERAL.—Section 852(b) is amended by striking paragraph (6). (b) EFFECTIVE DATE.—The amendments made by this section shall apply to taxable years beginning after December 31, 2022.
Simplicity itself. Section 852(b)(6) gives RICs (including ETFs) special tax treatment. So striking this section takes away that special treatment. ETFs would no longer be able to divest themselves of gain without owing taxes on the gain.
A different and more readable Section 138311 in the House document @msf cited says:
"this section prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021." [Emphasis mine.]
Comments
Those taxable account ETF investors can sell shares of their ETF's and receive cash on which they'd pay their fair share of taxes 'rather' than receiving (from the article) "A proposal has been drafted to change the law eliminating exchange traded funds’ chief tax advantage in the US by levying taxes on in-kind redemptions."
The average Joe ends up paying the taxes either way because few, if any, are "authorized participants" while those who are already exceedingly rich can game the system.
"Only “authorized participants” – a form of institutional investor – may redeem shares directly from an ETF. These investors are also able to contribute securities to a fund in exchange for newly issued ETF shares. Retail investors, on the other hand, can only buy and sell ETF shares through a broker."
From this article: What is an in-Kind Redemption
BTW, mutual funds can also avoid/minimize distributing capital gains under the current law if they are not lazy. (That is in addition to their ability to do in-kind redemptions.) You can read about it at Liberty Street Funds.
"Vanguard Group declined to comment on the proposal, but said “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.” For the majority of its U.S. ETFs, Vanguard uses a unique structure in which the firm’s ETFs are share classes of mutual funds.
In these cases, Vanguard’s ETFs can transfer appreciated stocks out of the mutual fund they are tied to in exchanges that don’t incur tax consequences for investors. This means that taxation of in-kind trades would affect both Vanguard’s ETFs and mutual funds.
Executives at Vanguard over the years had questioned whether the favorable tax treatment of in-kind trades would last, said a person familiar with the matter."
Similar article appeared in Barrons.
But hey, anyone of modest means please try to sell an ETF that you hold using an in-kind redemption and let us know how it works out.
https://www.investopedia.com/how-vanguard-patented-a-system-to-avoid-taxes-in-mutual-funds-4686985
There are other changes coming for high income individuals such as Roth conversion will be limited.
"In order to close so-called “backdoor” Roth IRA strategies, the bill eliminates Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation).
“This is similar to the old $100,000 income limitation for Roth conversions that existed before 2010, except now the income limits are increased to the $400,000/$450,000 levels,” Slott explained. “Oddly though, this proposal would not be effective for 10 years. The effective date says this would apply in years after Dec. 31, 2031.”
This change “would end Roth conversions for high-earners, but Congress still wants its conversion tax dollars. What to do?” Slott continued. “Maybe this delayed effective date shows us that Congress still needs this Roth conversion revenue so it can fill budget gaps, at least for the next 10 years. So, this provision is a non-issue for now.”
First, because the truly little guy is insulated from capital gain taxation - until one's taxable income exceeds $40,400 (single) or $80,800 (joint), cap gains are taxed at 0%. Second, because (at least as of 2012) only 1/3 of households even had taxable investment accounts, and I think it's a safe bet that these are largely not lower income households. "It is immediately clear that household income has the strongest relationship with taxable account ownership."
https://www.sec.gov/spotlight/fixed-income-advisory-committee/finra-investor-education-foundation-investor-households-fimsa-040918.pdf
The in-kind transaction loophole existed for all forms of businesses (corporations, funds, etc.) since 1935. Congress began narrowing it in 1969. It was little used until ETFs came along and exploited it. It has never made sense from a tax principle perspective - cap gains cannot simply go **poof**. Logically they should either accrue to the company (RIC) or if passed through, to the recipient. Jeffrey Colon, The Great ETF Tax Swindle: The Taxation of In-Kind Redemptions, 122 Penn St. L. Rev. 1 (2017)
Abstract: https://ir.lawnet.fordham.edu/faculty_scholarship/722/
Paper: https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1721&context=faculty_scholarship
As to the proposal, it is simplicity itself. Registered investment companies (OEFs and ETFs) are to be treated the same way as other companies. When they sell holdings, they are to recognize capital gains. Regardless of the form of the sale, i.e. regardless of whether they receive cash or fund shares in exchange for the securities they sell.
No more special cases. No special case because they're conducting an in-kind transaction. No special case because they're an OEF or ETF rather than a CEF.
ETFs would be expected to respond by selling their highest cost shares to the AP (authorized participant) rather than their lowest cost shares. At least if they cared about tax efficiency. That's the same method that OEFs use when raising cash to redeem shares.
Regarding Vanguard: Even before Vanguard started selling VIPERs (Vanguard Index Participation Receipts), their index funds tended to be the most tax efficient on the market. There were many years when their broad based index funds did not distribute cap gains. The proposed change should make Vanguard funds (and ETFs) look even better relative to their competition because of demonstrated skill in minimizing taxes.
Vanguard writes: “the ability of mutual funds and ETFs to transact securities in-kind is a longstanding practice that improves outcomes for millions of investors.” Funds could always transact in-kind.
ETFs fundamentally rely upon this ability in order to keep market price close to NAV. The proposed change does not affect their ability to transact in-kind. OEFs sometimes rely upon this ability as well. It is reasonably well known that Sequoia not only reserves the right to redeem shares in kind, but states explicitly that it is likely to do so for redemptions above $250K. Investors benefit because funds are not forced to conduct fire sales to meet large redemptions.
Sequoia Prospectus: It is highly likely that the Fund will pay you in securities or partly in securities if you make a redemption request (or a series of redemptions) in an amount greater than $250,000.
Wyden Proposal Would Impact ETF and Mutual Fund Redemptions-in-Kind and PTPs
ETF Giants Push Back Against Senate Democrat Who Wants to Take Away Tax Break
I believe this is the Melanie Waddell writing that syzygy quoted.
Ed Slott Weighs In on House Democrats' Proposed Mega-IRA Crackdown (from ThinkAdvisor)
The 881 page markup to the Build Back Better Act that contains the proposed backdoor Roth IRA changes:
https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/NEAL_032_xml.pdf
Thanks to davfor for the Wyden proposal link; it contains a link to the actual text:
https://www.finance.senate.gov/imo/media/doc/Pass-through Changes Discussion Draft Legislative Text.pdf
The part of the text that pertains to ETFs, in its entirety is: Simplicity itself. Section 852(b)(6) gives RICs (including ETFs) special tax treatment. So striking this section takes away that special treatment. ETFs would no longer be able to divest themselves of gain without owing taxes on the gain.
"this section prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021." [Emphasis mine.]
https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SubtitleISxS.pdf
https://www.marketwatch.com/story/congress-is-about-to-kill-this-popular-retirement-tax-move-11632861718