Seniors and ETFs: It’s About Taxes

Exchange-traded funds aren’t for retirees, industry experts often say.  

Turns out that not all financial advisors see it that way, and apparently, neither do seniors, who appear to be turning to them more frequently for flexibility and tax savings.  

“ETFs can be advantageous for seniors from a control-of-taxes perspective,” financial advisor Angela Palacios, CFP, at the Center for Financial Planning in Southfield, Michigan, told etf.com. 

Seniors are gravitating more toward ETFs, studies say, due to their liquidity, tax efficiency and relatively low-cost exposure to market returns. Vanguard Group, the No. 2 ETF issuer, says 18% of their over-65 clients hold exchange-traded funds. 

“The lower ETF penetration among seniors is largely because ETFs were not nearly as prevalent as mutual funds when today’s seniors started to invest,” James Martielli, Vanguard’s head of investment and trading services, said in an email. 

Twenty-two percent of ETF-owning households are retired, and the median age of ETF-owning households is 45 years old, according to the 2022 Investment Company Fact Book, published by Investment Company Research, a global association of regulated funds.  

“Retirees are concerned about income. Of course, they can purchase dividend-paying stocks or mutual funds, but ETFs offer diversification and tax efficiency,” said Marguerita Cheng, CEO of Blue Ocean Wealth. 

ETFs may appeal to seniors who must take required minimum distributions from IRA accounts after age 73. Taking the distribution might boost them into a higher tax bracket, and there’s no getting around that, Palacios said. 

“Owning an ETF, rather than a mutual fund, in a taxable account may grant more control over when the position incurs capital gains,” she said. “Mutual funds have much more potential than an ETF to distribute capital gains on an annual basis that the senior investor cannot control.” 

She added that if the RMD distributions are reinvested into a mutual fund, it can cause the cost basis to increase each year as the investor is paying taxes as they go, thereby causing the investor to foot more tax bills.   

“A step-up in basis at death of a mutual fund could be much less of a tax benefit than step-up in a similar ETF that doesn't distribute capital gains each year,” said Palacios.  

In addition, she said that an ETF with a low-cost basis can be held until the death of the investor, when it could then receive a step-up in cost basis. 

“This means the person, perhaps a child inheriting the position, would acquire that position with a new cost basis determined at the date of death, potentially avoiding paying taxes on gains accumulated throughout the senior's year of ownership.” 

Palacios sees the ETF pool getting wider and deeper. 

“I would expect ETF ownership to continue to grow among seniors, as I would expect it to grow among all investors,” she said. “Liquidity, tax benefits and the ability to gain inexpensive exposure to market returns are some of the reasons it will continue to grow.” 

Cheng recommends a handful of bond and dividend-paying stock ETFs. Stock funds include the Global X SuperDividend ETF (SDIV), the Vanguard High Dividend Yield ETF (VYM), the Vanguard Dividend Appreciation ETF (VIG) and the SPDR S&P Global Dividend ETF (WDIV). 

Among bonds, she suggests the iShares 10-20 Year Treasury Bond ETF (TLH), the iShares 7-10 Year Treasury Bond ETF (IEF), the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and the AXS Astoria Inflation Sensitive ETF (PPI). 

Follow Michelle Lodge at @lodgemich