When choosing between exchange-traded funds (ETFs) and mutual funds, it’s important to consider their tax benefits. While both offer diversification, ETFs generally provide better tax efficiency. A financial advisor can help explain how each is taxed, so you can pick the option that minimizes the tax impact on your returns.
Understanding ETFs and Mutual Funds
Before diving into the tax benefits, you should understand the fundamental differences between ETFs and mutual funds. Both are popular investment vehicles that allow individuals to pool their money with other investors to purchase a diversified portfolio of assets, but there are some key differences in how they’re structured and how they operate.
What Is an ETF?
An ETF is a type of investment fund that holds a basket of securities such as stocks, bonds or commodities. ETFs are traded on stock exchanges, similar to individual stocks and their price fluctuates throughout the trading day. One of the primary benefits of ETFs is that they offer diversification, allowing investors to gain exposure to a broad market or sector without needing to buy individual stocks or bonds.
ETFs also offer more liquidity, as investors can buy and sell shares at any time during the trading day. This differs from mutual funds, which are priced only at the end of the day. ETFs also tend to have lower expense ratios when compared with actively managed mutual funds, making them a cost-effective option.
What Is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from multiple investors to purchase a portfolio of stocks, bonds or other securities. Mutual funds can be actively managed, where a fund manager makes decisions about which assets to buy or sell, or passively managed, such as index funds that track a specific market index. Unlike ETFs, mutual funds are bought and sold at the end of the trading day at the fund’s net asset value (NAV).
Mutual funds are popular with investors who prefer a hands-off approach to investing, but they often come with higher management fees. Additionally, depending on the fund, they can be less tax-efficient than ETFs due to the way they distribute capital gains to shareholders.
Differences Between ETFs and Mutual Funds
There are key differences in how ETFs and mutual funds are traded, managed and taxed. Here are three to consider:
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Trading flexibility: ETFs are traded throughout the day on exchanges, while mutual funds can only be bought or sold at the end of the day at their NAV.
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Management style: ETFs are typically passively managed, tracking an index, while mutual funds may be actively or passively managed. Actively managed mutual funds usually come with higher fees.
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Tax efficiency: ETFs are generally more tax-efficient than mutual funds due to their unique structure, which allows them to avoid triggering taxable events as frequently as mutual funds do.
5 Tax Benefits of Investing in ETFs Over Mutual Funds
ETFs are often more tax-efficient than mutual funds, which can lead to significant savings over time. Here are five tax benefits of choosing ETFs over mutual funds:
1. Fewer Capital Gains Distributions
One of the main tax advantages of ETFs is their ability to minimize capital gains distributions. Mutual funds, especially actively managed ones, often buy and sell securities within the fund, triggering capital gains that are distributed to shareholders. These distributions are taxable, even if you haven’t sold any shares.
ETFs, by comparison, use something called creation units to collectively purchase blocks of shares, which allows them to avoid triggering taxable events. This structure means that ETF investors are less likely to face capital gains taxes unless they sell their shares directly.
2. Tax-Efficient Rebalancing
When mutual funds rebalance their portfolios, this often triggers capital gains that are passed on to shareholders, as mentioned above. ETF investors generally don’t experience this issue, as ETFs use creation units to adjust the fund’s holdings without selling securities on the open market.
This tax-efficient rebalancing process means that ETF investors are less likely to face unexpected tax liabilities due to internal trading. As a result, ETFs offer a more tax-friendly option for investors who want to minimize their tax exposure.
3. More Control Over Tax Timing
Since investors have more control over when they realize capital gains and pay taxes with ETFs, they have greater control over tax timing. With ETFs, investors are better able to strategically manage their tax liabilities and defer capital gains taxes until they decide to sell, which can be beneficial for long-term growth and tax planning.
4. Lower Turnover Rates
ETFs, particularly those that track indexes, tend to have lower turnover rates compared to actively managed mutual funds. A lower turnover rate means fewer trades within the fund, which reduces the likelihood of generating capital gains that need to be distributed to investors.
Mutual funds, especially actively managed ones, often have higher turnover rates. This is because managers periodically buy and sell stocks to try to beat an index. This recurring turnover can result in more frequent capital gains distributions that are taxed at the shareholder level. By investing in ETFs with low turnover rates, investors can benefit from more tax-efficient growth.
5. No Embedded Gains
When you buy shares of a mutual fund, you may inherit embedded gains, which are unrealized capital gains built up within the fund before your purchase. If the fund sells securities and distributes those gains, you could be taxed on them, even if you didn’t benefit from the previous growth.
With ETFs, you don’t inherit these embedded gains, as the tax liabilities are more individualized. This prevents you from being taxed on gains that occurred before you invested, offering a cleaner tax situation when compared with mutual funds.
Frequently Asked Questions
Are ETFs Always More Tax-Efficient Than Mutual Funds?
ETFs are generally more tax-efficient due to their structure, but certain mutual funds, like index funds, may offer comparable tax efficiency. Actively managed mutual funds tend to be less tax-efficient than ETFs.
How Do Capital Gains Distributions Work for Mutual Funds?
Mutual funds distribute capital gains to shareholders when the fund sells securities at a profit. These distributions are taxed as either short-term capital gains or long-term capital gains, depending on how long the assets were held.
Can I Avoid Capital Gains Taxes By Holding ETFs in a Retirement Account?
Yes, holding ETFs in a tax-advantaged account, such as an IRA or 401(k), allows you to defer taxes on capital gains. You won’t be subject to taxes on any gains until you withdraw funds from the account in retirement.
What Types of ETFs Are Most Tax-Efficient?
ETFs that track broad market indexes and have low turnover rates tend to be the most tax-efficient. These ETFs minimize trading and capital gains distributions, allowing investors to maximize tax-deferred growth.
Bottom Line
Both ETFs and mutual funds can benefit investors who want to diversify their portfolios. But these two types of investments differ when it comes to tax advantages. For those looking to minimize their tax burden, ETFs offer several advantages over mutual funds, including lower capital gains distributions, greater control over tax timing and more tax-efficient rebalancing.
Investment Planning Tips
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If maximizing your tax efficiency is an important investment goal, a financial advisor can work with you to optimize your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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If you want to know how much your portfolio could grow over time, SmartAsset’s free investment calculator can help you get an estimate.
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