ETFs and mutual funds are the two main types of managed accounts for investors. The IRS tax treatment of ETFs and mutual funds is the same, however, the structure of ETFs can make them a more tax-efficient option for taxable accounts.
Let’s take a look at why ETFs are generally more tax-efficient than mutual funds.
One of the biggest reasons for the generally greater tax efficiency of ETFs compared to their mutual fund counterparts are differences in structure. First, there is a higher percentage of actively managed mutual funds compared to the number of actively managed ETFs. The turnover in an actively managed fund is generally much higher during the year than with either an index mutual fund or ETF.
Even when compared to index mutual funds, ETFs still have the advantage when it comes to tax efficiency. Mutual funds, even passively managed index mutual funds, can be forced to generate capital gains inside of the fund when they need to raise cash to meet client redemption requests. When a mutual fund manager needs to raise cash, they need to sell stocks or bonds held inside the fund. This can lead to the generation of unplanned capital gain distributions, both long-term and short-term. These capital gains are passed through to all remaining shareholders of the mutual fund.
By contrast, only around 10% of the trades made by an ETF fund manager involve buying or selling the underlying securities held by the ETF. When ETF shareholders need to raise cash for whatever reason, they would simply sell some or all of their ETF shares during the trading day as they would with shares of an individual stock they might own. Any capital gains or losses realized by a shareholder of an ETF impact solely them and not the other ETF shareholders.
ETF managers manage investment inflows and outflows through the creation or redemption of creation units. These creation units allow the ETF manager to do in-kind redemptions and exchanges of individual securities for ETF shares, reducing the need to sell these individual securities for cash and generating capital gains inside of the ETF. This process can help eliminate or drastically reduce the generation of capital gains during the process of rebalancing the portfolio.
One aspect of mutual fund investing that can be very frustrating for investors are year-end distributions. In some years, mutual fund investors in taxable accounts may receive hefty capital gains distributions. This can be especially costly and frustrating if those capital gains are short-term gains that are taxed at their ordinary income tax rate. Often investors or their advisors must wait until the end of the year to find out what types of year-end, taxable distributions they are facing.
Like mutual funds, stocks, or other securities, ETF investors will incur capital gains taxes if they sell shares of an ETF and realize a gain on the sale. But in this case, the investor has control over when shares of an ETF are sold and the timing of any capital gains.
Dividends from both ETFs and Mutual funds may be taxed as qualified dividends if the investor has held the fund for at least 60 days. Qualified dividends are taxed at a rate ranging from 0% to 20%, depending upon the investor’s tax bracket. If the shares have been held for less than 60 days, then the dividends are taxed at the investor’s ordinary income tax rate.
Some international equity ETFs, both in developed and emerging markets, have the potential to be less tax efficient than domestic equity ETFs. Especially with emerging markets ETFs, there may be rules prohibiting in-kind exchanges. Some commodity and inverse ETFs also may not be as tax efficient as ETFs focusing on domestic equities and bonds.
In building our client model portfolios we use ETFs extensively in large part due to the tax efficiencies mentioned above. This is especially true for clients whose portfolios include taxable accounts. We feel that minimizing taxes is important not only for the current year's tax returns of our clients but minimizing taxes can help add to returns over a longer period of time.
Beyond taxes, ETFs offer several other advantages for our clients.
Our investment process is about balancing risk and reward for our clients as a key part of their overall financial planning strategy. The individual components of our investment models are each chosen based on our assessment of how they contribute to this overall goal. ETFs offer a number of advantages, even beyond their tax efficiency, which is why we use them in constructing client portfolios in both taxable accounts and in tax-advantaged accounts like IRAs.
To learn more about our investment strategies and how they can help you achieve your financial planning goals, please feel free to reach out.
Bill Canty, CFP®, CPA
Ed Canty, CFP®
Joe Canty, Investment Advisor Rep.
Maureen Walsh, EA, Investment Advisor Rep.
Tina Alteri, CPA, Tax Advisor