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Investors who hold exchange-traded funds can often escape a tax bill incurred by investors with mutual funds, which investment experts say are generally less tax efficient.
ETFs and mutual funds are baskets of stocks, bonds and other financial assets overseen by professional money managers. But they have a different legal structure that gives ETFs a “tax magic unmatched by mutual funds,” Bryan Armour, the director of passive strategies research for North America and editor of the ETFInvestor newsletter at Morningstar, wrote this year.
These tax savings relate to the annual distributions of capital gains within the funds.
Capital gains tax is payable on investment gains.
Fund managers may generate such taxes within a fund when they buy and sell securities. The taxes are then passed on to all fund shareholders, who are liable for a tax assessment even if they reinvest those distributions.
ETFs’ tax benefit comes from “in-kind creations and redemptions,” which essentially allow tax-free transactions for many ETFs, experts explain. (The ETF’s in-kind transaction mechanism is somewhat complex. At a high level it is implies large institutional investors, called “authorized participants,” who create or redeem ETF shares directly from the ETF provider.)
The tax benefit is generally clearest for equity funds, they said.
For example, more than 60% of stock funds will have paid out capital gains by 2023, according to Morningstar. This applied to only 4% of the ETFs.
Less than 4% of ETFs are expected to pay out capital gains in 2024, according to Morningstar estimates. Such data is not yet available for investment funds.
Importantly, this tax benefit is only relevant to investors who hold money in taxable accounts, experts said.
It’s a moot point for investors in retirement accounts, such as those with a 401(k) plan or an individual retirement account, which already offer tax benefits, experts say.
The tax benefit “really benefits the non-IRA account more than anything,” says Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida, and a founding partner of Moisand Fitzgerald Tamayo.
“You get tax efficiencies that, without a doubt, a standard mutual fund will not be able to achieve,” he said.
However, ETFs don’t always offer a tax benefit, experts say.
For example, certain ETF holdings may not benefit from in-kind transactions, Armor said.
Examples include physical commodities, as well as derivatives such as swaps, futures contracts, forward currency contracts and certain options contracts, he said.
In addition, certain countries such as Brazil, China, India, South Korea and Taiwan may consider in-kind redemptions of securities domiciled in those countries as taxable events, he said.
