Tax considerations for mutual funds and exchange-traded funds (ETFs) are similar in many ways; both are taxed on dividends and capital gains distributions as well as gains resulting from market transactions. However, due to their inherent structure, ETFs can often be more tax-efficient than mutual funds. Learn the differences between ETFs and mutual funds when it comes to tax efficiency.
Key Takeaways
- Exchange-traded fund (ETF) and mutual fund capital gains resulting from market transactions are taxed based on whether the investment was held short-term or long-term.
- Capital gains distributions from mutual funds (and ETFs on occasion) are taxed at the long-term capital gains rate.
- Comprehensively, ETFs don't often have capital gains distributions, which makes them more tax-efficient than mutual funds.
ETF vs. Mutual Fund Tax Efficiency: An Overview
To understand the differences between tax considerations for ETFs and mutual funds, it helps to start with the basics for taxable investments.
The U.S. government requires a portion of nearly every type of income that an American receives. Therefore, while there are tax efficiencies to be considered, investors must plan on paying at least some tax on all dividends, interest, and capital gains from any type of investment unless designated tax exemptions apply.
There are some exemptions to taxation, such as Treasury and municipal securities. As such, an ETF or mutual fund in these areas would have tax-exempt characteristics.
Keep in mind there can also be some tax exceptions for both ETFs and mutual funds held in retirement accounts, as those are typically tax-advantaged accounts.
Capital Gains vs. Ordinary Income
Capital gains on most investments are taxed at either the long-term capital gains rate or the short-term capital gains rate.
ETF and mutual fund share transactions follow the long-term and short-term standardization of capital gains treatment. However, the one-year delineation does not apply to ETF and mutual fund capital gains distributions, which are when the fund manager sells some of the fund's assets for a capital gain and passes the earnings along. These are all taxed at the long-term capital gains rate. Capital gains distributions tend to be minimal for ETFs and are more associated with mutual funds.
Long-term capital gains refer to gains occurring from investments sold after one year and are taxed at either 0%, 15%, or 20% depending on the tax bracket. Short-term capital gains refer to gains occurring from investments sold within one year and are all taxed at the taxpayer’s ordinary income tax rate.
Dividends
Dividends can be another type of income from ETFs and mutual funds. Dividends will usually be separated by qualified and non-qualified (ordinary), which each have different tax rates.
Overall, any income an investor receives from an ETF or mutual fund will be delineated clearly on an annual tax report used for reference in the taxpayer’s tax filing.
Oftentimes, investment advisors may suggest ETFs over mutual funds for investors looking for more tax efficiency. This advice is not a mere matter of the difference in taxes for ETFs vs. mutual funds, since both may be taxed the same, but rather a difference in the taxable income that the two vehicles generate due to their unique attributes.
ETF Taxes
ETFs are considered slightly more tax-efficient than mutual funds for two main reasons.
First, ETFs have a unique mechanism for buying and selling. ETFs use creation units that allow for the purchase and sale of assets in the fund collectively. This means that ETFs usually don't generate the capital gains distributions that mutual funds do, and therefore don't see the tax effects of those distributions.
Second, the majority of ETFs are passively managed, which in itself creates fewer transactions because the portfolio only changes when there are changes to the underlying index it replicates. Actively managed funds, in contrast, experience taxable events when selling the assets within them.
ETFs can be composed of many different types of securities, from stocks and bonds to commodities and currency. The U.S. Securities and Exchange Commission approved 11 new spot bitcoin ETFs in January 2024, broadening investor access to cryptocurrency via ETF.
Mutual Fund Taxes
Mutual fund investors may see a slightly higher tax bill on their mutual funds annually. This is because mutual funds typically generate higher capital gains due to the way they're managed.
Mutual fund managers buy and sell securities for actively managed funds based on active valuation methods, which allow them to add or sell securities for the portfolio at their discretion. Managers must also buy and sell individual securities in a mutual fund when accommodating new shares and share redemptions. These transactions typically pose a taxable event.
Fund Management and Taxation
The type of securities in a fund affects its taxation. Funds that include high dividend or interest-paying securities, regardless of whether they're an ETF or a mutual fund, will receive more pass-through dividends and distributions which can result in a higher tax bill.
Managed funds that actively buy and sell securities, and thus have larger portfolio turnover in a given year, will also have a greater opportunity of generating taxable events in terms of capital gains or losses. This is why mutual funds create a lot of capital gains distributions, especially in comparison to ETFs.
Other Advantages of ETFs Over Mutual Funds
ETFs have some additional advantages over mutual funds as an investment vehicle beyond tax efficiency.
- Transparency: ETF holdings can be freely seen day-to-day, while mutual funds only disclose their holdings every quarter.
- Greater liquidity: ETFs can be traded throughout the day, but mutual fund shares can only be bought or sold at the end of a trading day. This can have a significant impact on an investor when there is a substantial fall or rise in market prices by the end of the trading day.
- Generally lower expense ratios: The average expense ratio for an ETF is less than the average mutual fund expense ratio.
Are ETFs More Tax Efficient Than Mutual Funds?
Generally, yes, ETFs are considered more tax efficient than mutual funds, as they tend to have fewer capital gains distributions and therefore fewer opportunities for taxation.
What Is the Tax Loophole for ETFs?
The so-called "tax loophole" for ETFs has to do with the wash-sale rule, which is the IRS rule prohibiting investors from selling an investment to claim the loss and then buying a "substantially identical" security to replace it in their portfolio. Because exchange-traded funds are typically based on an index and not a single stock, they avoid the "substantially identical" problem.
Do I Pay Taxes on an ETF if I Don’t Sell?
It depends. You may need to pay taxes if the ETF holds dividend-paying stocks or interest-yielding bonds, even if you're holding on to the ETF for the long-term.
The Bottom Line
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
