This post is the fifth in a five-part series outlining the primary benefits of the Couch Potato strategy.

All investors have to deal with the erosion of their returns by fees and taxes. The first post in this series explained how using ETFs and index funds can cut your costs by 90% or more. Now let’s look at how index investing can also cut your tax bill.

Fair warning: this subject is rather technical and it may leave beginners baffled. The good news is that if all your investments are in registered accounts—RRSPs, RRIFs, RESPs or Tax-Free Savings Accounts—you don’t need to worry about it. But if you’re investing in a taxable account with actively managed mutual funds, you may want to settle in. It just might save you some money.

Most mutual funds are structured as open-end trusts, which enables them to avoid paying taxes. Instead, funds pass along any interest, dividends and capital gains to their unitholders. (Mutual funds incur a capital gain any time they sell stocks, bonds or other securities at a profit.) Usually all of these distributions are reinvested rather than paid in cash, but unitholders are still responsible for paying tax on them: that’s why you get that T3 slip in the mail every year.

Most investors expect to pay capital gains taxes if they sell their own mutual fund units at a profit. But the point here is that unitholders are hit with taxes even if they hold onto the fund.

In fact, they may even be on the hook for the decisions of other investors. Here’s why: when unitholders panic during a market downturn, the fund may be forced to sell securities in order to pay all those redemptions. If those sales incur capital gains, the remaining unitholders wind up footing the bill for those who bailed. It’s bad enough paying taxes on your profits. But imagine the shock of watching the value of your funds plummet during a crash, and then taking a second hit when you’re forced to pay capital gains taxes despite huge losses. (You can read a CNN Money account of how this happened to investors in 2008. It’s a US article, but the relevant tax laws in Canada are similar.)

Investors who unwittingly buy a mutual fund late in the year may also get a nasty surprise from the taxman. If the fund pays a capital gains distribution at year end, a new investor must pay tax on it even if the actual gain was incurred long before she bought into the fund. How fair is that? (For more, see this post at Where Does All My Money Go?)

Index fund investors must pay capital gains taxes, too, but because these funds passively track an index, they trade far less than actively managed mutual funds, and are therefore far less likely to realize gains.

More important for Couch Potato investors, ETFs are cleverly designed so that some are able to virtually eliminate taxable gains. The structure is complicated, but the basic idea is that ETFs do not have to keep cash on hand to pay investors who redeem their shares. The underlying stocks or bonds in an ETF are held by a third party called a designated broker, and the creation and redemption of units are made through in-kind swaps between this broker and the ETF sponsor. Because no cash exchanges hands, no taxable event is generated, and no capital gain is passed on to the investor. The system is not perfect, but many iShares and Claymore ETFs have never passed along a cent in capital gains to their unitholders. (If you want to better understand this arcane but perfectly legal structure, this article may help.)

If all of this makes your head spin, don’t sweat it. Just understand the key point: most ETF investors will never pay capital gains taxes unless they decide to sell their own shares at a profit. The tax efficiency of ETFs is one more way of making sure that more of your investment returns stay where they belong: in your pocket.

Part 1 : Low costs

Part 2: Pure asset allocation

Part 3: Transparency

Part 4: Flexibility