Why Are ETFs More Tax Efficient Than Mutual Funds?

Exchange-Traded Funds (ETFs) and mutual funds both allow individuals to own a diversified collection of assets. While they share similarities, a primary advantage of ETFs is their tax efficiency. This benefit stems from the unique way ETFs are structured and traded, which differs from traditional mutual funds and can result in a lower tax bill for an investor.

The Mutual Fund Tax Structure

A traditional mutual fund’s structure creates tax liabilities for its investors. When a shareholder sells their shares, they redeem them directly from the fund company. To pay the departing investor, the fund manager must often sell some of the fund’s underlying securities to raise cash.

If these securities have appreciated in value, their sale triggers a capital gain. The Investment Company Act of 1940 requires mutual funds to distribute nearly all realized capital gains to their shareholders annually. These distributions are taxable events for the shareholders who receive them.

This process means all shareholders, even those who haven’t sold their own shares, must pay taxes on gains from the fund’s internal trading. An investor could have an unrealized loss on their investment but still receive a taxable capital gains distribution, highlighting a lack of control over the timing of tax events.

The ETF Creation and Redemption Mechanism

An ETF’s tax advantage comes from its creation and redemption process, which involves an intermediary known as an Authorized Participant (AP). APs transact with the ETF provider using an “in-kind” system, which avoids the forced selling of securities common in mutual funds.

To redeem a large block of ETF shares, an AP delivers the shares to the fund sponsor. In return, the sponsor gives the AP a basket of the actual underlying securities the ETF holds, not cash.

Because the ETF is not selling securities for cash to meet the redemption, it does not realize a capital gain. This transfer of securities is not a taxable event for the fund, preventing the creation of gains that would be distributed to remaining shareholders. This mechanism allows the ETF to remove low-cost-basis shares from its portfolio without triggering taxes.

Impact of Portfolio Turnover

The investment strategy of most ETFs also contributes to their tax efficiency. The majority are passively managed to track a market index, like the S&P 500. This approach results in a low portfolio turnover rate, which measures how often assets are bought or sold.

An index-tracking ETF only trades securities when its underlying index changes. In contrast, many mutual funds are actively managed, with managers frequently buying and selling assets to outperform the market, leading to higher turnover.

A higher turnover rate increases the likelihood of realizing capital gains from selling appreciated securities. The frequent trading in an actively managed mutual fund can generate a stream of capital gains that must be distributed to shareholders. The low-turnover nature of most ETFs means fewer internal sales and fewer taxable distributions.

Tax Implications for the Investor

For the individual investor, these factors mean ETFs generate far fewer annual capital gains distributions than their mutual fund counterparts. This gives the investor more control over their tax situation. A taxable capital gain is realized only when the investor sells their shares on the stock exchange.

This control allows for strategic tax planning. An investor can hold an ETF for more than one year to qualify for lower long-term capital gains tax rates, which for 2025 are 0%, 15%, or 20% depending on taxable income. Deferring taxes allows investment returns to compound without being reduced by annual tax payments.

Not all ETFs are equally tax-efficient. Actively managed ETFs may have higher turnover that leads to capital gains. Additionally, ETFs holding assets like commodities or currencies are subject to different and more complex tax rules.