Investors holding exchange-traded funds (ETFs) often dodge the tax bills that those owning mutual funds face. Experts in the investment world have noticed that mutual funds tend to be less tax-efficient compared to ETFs.
Both ETFs and mutual funds are collections of stocks, bonds, and various financial assets managed by professionals. However, what sets them apart is their legal framework, which grants ETFs a unique tax efficiency that mutual funds simply can’t match, as highlighted by Bryan Armour. Armour, who leads passive strategies research for North America and edits the ETFInvestor newsletter at Morningstar, described this as “tax magic.”
A critical aspect of this tax efficiency is related to the annual capital gains distributions that occur within these funds. Investors need to pay taxes on the profits made from these capital gains. Fund managers inevitably generate these taxes when they buy and sell securities within the fund. Consequently, these taxes are passed on to all shareholders, who are liable for taxes even if they reinvest these distributions.
The secret behind ETFs’ tax edge lies in “in-kind creations and redemptions.” This mechanism, which allows for many ETFs to trade tax-free, is somewhat intricate. Essentially, it involves large institutional investors, known as “authorized participants,” who manage the creation or redemption of ETF shares directly with the ETF issuer.
This tax advantage tends to be most noticeable with stock funds. For instance, over 60% of stock mutual funds distributed capital gains in 2023, according to Morningstar. In contrast, only 4% of ETFs did the same. As for 2024, less than 4% of ETFs are expected to distribute capital gains, although data for mutual funds is not yet available.
It’s important to note that this tax advantage significantly benefits investors who hold funds in taxable accounts. For those with retirement accounts like a 401(k) or an IRA, which already offer tax benefits, this edge doesn’t really come into play.
Charlie Fitzgerald III, a certified financial planner in Orlando, Florida, and a founding member of Moisand Fitzgerald Tamayo, points out that non-IRA accounts stand to gain the most from this tax efficiency. “You’ll have tax efficiency that a standard mutual fund is not going to be able to achieve, hands down,” he states.
That being said, ETFs don’t always carry a tax advantage. Bryan Armour noted that certain types of ETF holdings, such as physical commodities, derivatives like swaps, futures contracts, currency forwards, and certain options contracts, may not benefit from in-kind transactions.
Moreover, countries like Brazil, China, India, South Korea, and Taiwan might consider in-kind redemptions of securities domiciled there as taxable events, he added.
