ETF versus Mutual Fund Taxes - Fidelity (2024)

In a nutshell, ETFs have fewer "taxable events" than mutual funds—which can make them more tax efficient. Find out why.


ETF versus Mutual Fund Taxes - Fidelity (1)

ETFs can be more tax efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account.

From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and the ultimate tax bill (after the ETF is sold and capital gains tax is incurred) is less than what the investor would have paid with a similarly structured mutual fund.

Taxable events in ETFs

In essence, there are—in the parlance of tax professionals—fewer “taxable events” in a conventional ETF structure than in a mutual fund. Here’s why:

A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment.

In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure.

To be fair to mutual funds, managers take advantage of carrying capital losses from prior years, tax-loss harvesting, and other tax mitigation strategies to diminish the import of annual capital gains taxes. In addition, index mutual funds are far more tax efficient than actively managed funds because of lower turnover.

ETF versus Mutual Fund Taxes - Fidelity (2)

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ETF capital gains taxes

For the most part, ETF managers are able to manage the secondary market transactions in a manner that minimizes the chances of an in-fund capital gains event. It's rare for an index-based ETF to pay out a capital gain; when it does occur it's usually due to some special unforeseen circ*mstance.

Of course, investors who realize a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%. These percentages are based upon your taxable income and—depending on your modified adjusted gross income (AGI)—you might have to pay an additional 3.8%. The important point is that the investor incurs the tax after the ETF is sold.

Taxation of ETF dividends

ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor’s income tax rate. If the dividend was held less than 60 days before the dividend was issued, then the dividend income is taxed at the investor’s ordinary income tax rate. This is similar to how mutual fund dividends are treated.

Exceptions to the rules

Certain international ETFs, particularly emerging market ETFs, have the potential to be less tax efficient than domestic and developed market ETFs. Unlike most other ETFs, many emerging markets are restricted from performing in-kind deliveries of securities. Therefore, an emerging-market ETF might have to sell securities to raise cash for redemptions instead of delivering stock. This sale would cause a taxable event and subject investors to capital gains.

Leveraged/inverse ETFs have proven to be relatively tax-inefficient vehicles. Many of the funds have had significant capital gain distributions on both the long and the short funds. These funds generally use derivatives—such as swaps and futures—to gain exposure to the index. Derivatives cannot be delivered in kind: They must be bought or sold. Gains from these derivatives generally receive 60/40 treatment by the IRS, which means that 60% are considered long-term gains and 40% are considered short-term gains regardless of the contract's holding period. Historically, flows in these products have been volatile, and the daily repositioning of the portfolio to achieve daily index tracking triggers significant potential tax consequences for these funds.

Commodity ETPs have a similar tax treatment to leverage/inverse ETFs because of the use of derivatives and the 60/40 tax treatment. However, commodity ETPs do not have the daily index tracking requirement or use leverage/short strategies, and they have less volatile cash flows simply due to the nature of the funds.

Exchange traded notes (ETNs)

The most tax efficient ETF structure are exchange traded notes. ETNs are debt securities guaranteed by an issuing bank and linked to an index. Because ETNs do not hold any securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN. ETN shares reflect the total return of the underlying index; the value of the dividends is incorporated into the index's return, but are not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs that regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. But like conventional ETFs, when the investor sells the ETN, they are subject to a long-term capital gains tax.

ETF versus Mutual Fund Taxes - Fidelity (2024)


Are ETFs or mutual funds better for taxes? ›

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. Internal Revenue Service.

Do ETFs have better returns than mutual funds? ›

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often.

How to avoid the mutual fund tax trap? ›

Tactics for reducing your exposure to capital gains taxes
  1. Make sure your investments are in the appropriate accounts. ...
  2. Seek out tax-managed mutual funds. ...
  3. Consider swapping out your mutual funds for exchange-traded funds (ETFs). ...
  4. Explore the potential benefits of a separately managed account (SMA).

Do I pay taxes on ETFs if I don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

How to avoid capital gains tax on ETF? ›

One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Why would someone choose an ETF over a mutual fund? ›

ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.

Why would you choose ETFs over mutual funds? ›

You're tax sensitive

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds.

Why use ETFs over mutual funds? ›

ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

What are the tax disadvantages of mutual funds? ›

Disadvantages include high fees, tax inefficiency, poor trade execution, and the potential for management abuses.

How do you avoid double taxation on mutual funds? ›

6 quick tips to minimize the tax on mutual funds
  1. Wait as long as you can to sell. ...
  2. Buy mutual fund shares through your traditional IRA or Roth IRA. ...
  3. Buy mutual fund shares through your 401(k) account. ...
  4. Know what kinds of investments the fund makes. ...
  5. Use tax-loss harvesting. ...
  6. See a tax professional.
Aug 31, 2023

Why are mutual funds tax inefficient? ›

If your mutual fund contains investments in dividend-paying stocks or bonds that pay periodic interest, called coupon payments, then you likely receive one or more dividend distributions a year. While this may be a convenient source of regular income, the benefit may be outweighed by the increase in your tax bill.

Are mutual funds more tax-efficient? ›

While this may be a convenient source of regular income, the benefit may be outweighed by the increase in your tax bill. Most dividends are considered ordinary income and are subject to your normal tax rate. Mutual funds that do not pay dividends are thus naturally more tax-efficient.

Which of the following funds are usually most tax-efficient? ›

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.

Do ETFs have lower expenses than mutual funds? ›

ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments. And ETFs do not have 12b-1 fees.

Why are ETFs good for taxable accounts? ›

For investors who like the convenience and built-in diversification of a mutual fund, equity exchange-traded funds can make fine, tax-efficient options for taxable accounts. Most ETFs track indexes, so their turnover is often very low, meaning that capital gains distributions also tend to be few and far between.

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