Tax Efficiency Differences: ETFs vs. Mutual Funds (2024)

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 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.

Tax Efficiency Differences: ETFs vs. Mutual Funds (2024)


Tax Efficiency Differences: ETFs vs. Mutual Funds? ›

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.

Are ETFs more tax-efficient than mutual funds? ›

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

What are 2 key differences between ETFs and mutual funds? ›

While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed. Active mutual funds are managed by fund managers.

What is 1 benefit and 1 drawback of an ETF compared to a mutual fund? ›

Quick Reference Comparison
ETFsMutual Funds
PricingDetermined by marketNet asset value (NAV)
Tax EfficiencyUsually tax efficient due to less turnover and fewer capital gainsNot as tax efficient due to more turnover and greater capital gains
Automatic InvestingNot availableYes, for investments and withdrawals
9 more rows

Is Voo or VTI more tax-efficient? ›

Generally, ETFs will have a slight edge from a tax efficiency perspective. ETFs tend to distribute comparatively fewer capital gains to shareholders – these same gains are simply more challenging to manage efficiently from a mutual fund. Overall, VOO and VTI are considered to have the same level of tax efficiency.

Why are ETFs better than mutual funds for taxes? ›

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

Why are ETFs more efficient 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. However, ETFs also have a structural ability, called the in-kind creation/redemption mechanism, to minimize the capital gains they distribute.

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.

What are 3 differences between mutual funds and ETFs? ›

Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.

What is the biggest difference between ETF and mutual fund? ›

Mutual funds are usually actively managed, although passively-managed index funds have become more popular. ETFs are usually passively managed and track a market index or sector sub-index. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.

Are ETFs less tax-efficient than mutual funds? ›

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 you pay taxes on ETFs if you 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.

Why are ETFs so much cheaper than mutual funds? ›

The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.

What is the ETF tax loophole? ›

That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy. The ETF tax loophole works only on capital gains, though.

How much more tax wise are ETFs vs mutual funds? ›

Is an ETF more tax-efficient than a mutual fund? In terms of capital gains and losses and dividends, tax law treats these the same for ETFs and mutual funds. However, one benefit of ETFs is that they often encounter fewer taxable events. Because ETFs trade on an exchange, they transfer from one investor to another.

Which ETF is most tax-efficient? ›

Top Tax-Efficient ETFs for U.S. Equity Exposure
  • iShares Core S&P 500 ETF IVV.
  • iShares Core S&P Total U.S. Stock Market ETF ITOT.
  • Schwab U.S. Broad Market ETF SCHB.
  • Vanguard S&P 500 ETF VOO.
  • Vanguard Total Stock Market ETF VTI.

Why are ETFs so tax-efficient? ›

Since these transactions occur between two market participants and not the fund itself, existing shareholders are insulated from others actively buying and selling shares – thus avoiding taxable transactions within the ETF.

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.

Top Articles
Latest Posts
Article information

Author: Delena Feil

Last Updated:

Views: 5912

Rating: 4.4 / 5 (45 voted)

Reviews: 92% of readers found this page helpful

Author information

Name: Delena Feil

Birthday: 1998-08-29

Address: 747 Lubowitz Run, Sidmouth, HI 90646-5543

Phone: +99513241752844

Job: Design Supervisor

Hobby: Digital arts, Lacemaking, Air sports, Running, Scouting, Shooting, Puzzles

Introduction: My name is Delena Feil, I am a clean, splendid, calm, fancy, jolly, bright, faithful person who loves writing and wants to share my knowledge and understanding with you.