An efficient ETF portfolio will help you build net worth faster. There are many attributes to look at when choosing an ETF. Examples are tracking index, TER, fund size, bid-ask spread, domicile and legal aspects (e.g. UCITS). This entry focuses on yet another important consideration: the choice of accumulating vs distributing ETFs.
Accumulating vs distributing ETFs – the basics
In essence, the difference between accumulating and distributing funds lies in how they handle dividends. Distributing ETFs pay dividends to investors. Accumulating ETFs automatically reinvest dividends back into the fund.
Here’s another way to look at it. Because distributing ETFs pay out dividends, they track a price index. This could be, for example, the S&P 500 index. Accumulating ETFs track a total return (TR) index. For example, the S&P 500 Total Return index. Why are these two indices different? Because one reinvests dividends back into the fund. The other doesn’t. Over the long run (say 30 years), the effect of reinvesting dividends is huge:
This is not to say that accumulating ETFs provide higher returns. If you hold a distributing ETF, you can ride the red curve as well. You simply have to reinvest all dividends received yourself. If you fail to do so, you’re stuck with the blue line.
Accumulating vs distributing ETFs – which one is better for me?
Are you struggling with which type of ETF to choose? Here are four points you should consider.
This seems to be a winning argument among new investors. Accumulating ETFs liberate you from the hassle of reinvesting dividends yourself. Why not using them? Putting your dividends back into the fund yourself isn’t that much of an effort. But having to do nothing at all is even better, right?
This is when things get interesting. Switzerland taxes your income, including dividends and coupons. However, Switzerland doesn’t tax your capital gains (unless you’re a professional trader). With an accumulating ETF, you don’t receive any dividend. Instead, you see the effect of dividends translated into capital gains. Does that mean that you’re tax free with an accumulating ETF? No.
As a Swiss investor, you don’t stop paying tax on dividends if you hold an accumulating ETF
Distributing ETFs are easy to tackle from a tax perspective. On the one hand, you explicitly receive dividends. And dividends are taxed at your marginal income tax rate. On the other hand, you benefit from capital gains. These capital gains aren’t taxes. At least not if you follow the basic rules explained here.
What about accumulating ETFs? With accumulating ETFs, dividend income and capital gains are somewhat coupled. As explained in this entry, the Swiss tax authorities have a tool call ICTax. You provide the tool with ISIN, and it spits out the taxable dividends associated to the given ISIN. For accumulating ETFs, the taxable dividends are equivalent to those of a distributing ETF in the best case scenario. In the worst case scenario (e.g. tax authorities have no data), you might end up paying more. Or at the very least having to spend time doing your own math and fighting the tax office.
In general, taxation should be equivalent for distributing and accumulating ETFs. The extra transparency of distributing ETF, however, puts you in a better spot when it comes to taxes.
Accumulating ETFs aren’t always available. For example, I don’t know of any accumulating US domiciled ETF. Because US-domiciled ETFs are more efficient than Irish- or Swiss-domiciled, I personally stick to distributing ETFs.
In general, you achieve lower fees with a distributing ETF. By lower fees I mean both TER and transaction fees. Why is this the case? Once again, because US-domiciled funds are the most cheapest. And they’re always distributing.
Everything said until now applies to Switzerland. Especially in terms of tax implications. If you don’t pay taxes in Switzerland, the points above might not apply to you.
In some countries (e.g. Belgium, Spain), accumulating ETFs are superior. They make it possible to avoid dividend taxes altogether. In other countries (e.g. Germany), you still pay dividend taxes on accumulating ETFs. And the process is much more cumbersome than in Switzerland.
You should do your own research. This is a good starting point.
Think carefully about the type of ETF you choose. Accumulating ETFs are convenient to baghold, but also have several drawbacks. If you invest in US equities (and trust this article), you should go for distributing ETFs. You’ll pay less taxes, fees and TERs. You’ll also be shielded from potential headaches when filing your taxes.
If you’re not taxed in Switzerland, tax implications might be different. In some countries, it’s superior to hold accumulating ETFs. You have to do you own research.