In the decade after the dot-com stock boom ended, investors were in for a surprise. Even though many of their mutual funds lost value in the first few years of that decade, they still owed taxes.

How's that?

Well, mutual funds do their own buying and selling, and even in a year when the fund lost value, the fund managers may have still sold their positions in winning stocks. And because the mutual fund must reflect capital gains on those trades, so must you.

A Solution Other Than Mutual Funds

Fast forward to 2013, and many investors have ditched their mutual funds, shifting their cash to lower-cost exchange-traded funds (ETFs). Whereas most mutual funds charge annual fees approaching 2% or even 3%, ETFs typically charge less than 1% annually. In some instances, such as the Vanguard S&P 500 ETF (NYSE: VOO), the expense can be an absurdly low 0.05%. Add it up over the years, and these small differences in annual expenses can yield big savings for your portfolio.

But as is the case with mutual funds, ETFs have tricky tax codes that can trip up unwitting investors. And in a moment, I'll explain how you can side-step the whole mess.

Many ETFs, even if they didn't rise in value in the past year, can trigger capital gains. And depending on what investors own, the tax rate can become burdensome. Uncle Sam, for reasons that are not fully clear to most of us, applies different capital gains tax rates to different types of assets. Whether these ETFs own stocks, commodities, futures contracts or currencies, the taxes you'll owe vary.

But there's a solution.

Tax Laws

First, here's a closer look at the tax laws.

The majority of ETFs own stocks, and since they tend to simply buy and hold those stocks, they don't generate an especially large amount of capital gains during years when they lose value (unlike mutual funds, which have a high degree of asset turnover and therefore might trigger capital gains in good years and bad).

As is the case with stocks, your ETF holding period matters. If you own a stock-focused ETF for more than one year, then you'll be taxed at the long-term capital gains rate, which currently stands at 0% if you are in a 10% of 15% income tax bracket, or 15% capital gains tax rate if your income tax bracket is higher. Yet, if you hold that ETF for less than a year, then the taxes you owe are the same as your income tax rate.

ETF Tax Implications

But if you own an ETF that focuses on other assets, then the tax implications can become tricky. Here's a short explanation of the distinctions:

  • Currency-focused ETFs, such as the PowerShares DB US Dollar Index Bullish ETF (NYSE: UUP), are set up under special financial arrangements known as 'grantor trusts.' These trusts simply pass on gains and losses to investors, without any special capital gains treatments. An exception is made for ETFs that solely own foreign currencies, which are taxed as ordinary income.
  • Futures-focused ETFs, such as the PowerShares DB Commodity Index Tracking ETF (NYSE: DBC), are treated as if they generate 60% long-term capital gains and 40% short-term capital gains. If you are looking to buy these ETFs, call the fund sponsor and talk to a service representative about the real-world tax implications of such funds.
  • Precious metals-focused ETFs that own items such as gold bullion or physically hold other precious metals, such as the SPDR Gold Shares (NYSE: GLD), are treated as if they are collectible items. The taxes on these assets are treated as ordinary income if you hold them for less than a year, but are taxed at a rate of 28% if they are held for a longer timeframe. Here again, a call to the fund sponsor's hotline is advisable to understand the tax ramifications.

One Easy Trick

But I've found a way to skirt around the tax burden of ETFs. Here it is...

Thanks to the unnecessary complexity of all of these tax rules, it may be wisest to avoid the problem altogether. You can do that by keeping all of your ETF investments in retirement accounts such as 401(k)s and IRAs. Instead of figuring out your tax bite year after year, you'll simply owe taxes on profits accrued for the lifetime of that retirement account, once you start to withdraw funds after age 59 1/2.

For that matter, you should assess almost of all of your investment choices in the context of your taxable vs. non-taxable investment portfolios. In most instances, the non-taxable portfolios such as IRAs or 401(k)s should be the primary recipient of your investment dollars. Although these funds eventually will be taxed when you start to make withdrawals, you are likely to be in a lower tax bracket -- if you have stopped working.

The Investing Answer: There are many good reasons to invest in ETFs, including portfolio diversification and the simplicity of asset allocation. And although they have fewer tax implications than mutual funds, they still can trigger an unexpected tax bite. The major sponsors of ETFs such as Barclays, Wisdom Tree, Vanguard and others can furnish you with brochures that spell out the tax implications for each of the funds you may be considering. These tax complexities may seem daunting initially, but once you have a grasp on the issue, you'll be ready to capitalize on this important emerging form of investing.