ETFs vs. Mutual Funds Tax Efficiency: Understand the Key Differences

Both ETFs and mutual funds allow you to invest in a basket of securities — such as stocks or bonds — within a single investment. Both are taxed on capital gains and dividends and both are subject to the same tax rates based on short-term or long-term holdings.

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ETFs are inherently more tax efficient due to how the investments are structured. Investors may be able to save some money by understanding how ETFs and mutual funds are taxed. Here’s everything you need to know about ETF vs. mutual fund tax efficiency.

Overview of ETFs and Mutual Funds

ETFs and mutual funds can hold very similar investments, such as stocks, bonds, U.S. Treasuries, commodities and other securities. And both are taxed in a similar way:

• Dividends paid out by a mutual fund or ETF are taxed at your ordinary income tax rate.

• Holding an ETF or mutual fund for less than one year and selling will result in a short-term capital gain or loss.

• Holding an ETF or mutual fund for more than one year and selling will result in a long-term capital gain or loss.

• Both mutual funds and ETFs benefit from holding tax-efficient investments, such as Treasuries or municipal bonds.

• Mutual funds and ETFs held in tax-advantaged accounts can grow tax-free — dividends and capital gains are either deferred until withdrawal or entirely tax-free in Roth accounts.

There are a few distinctions to keep in mind when choosing between an ETF vs. mutual fund that could have tax implications.

How ETFs and Mutual Funds Work

Mutual funds are a type of investment fund that holds multiple investments, such as stocks, bonds, U.S. Treasuries or other investments. Mutual funds are typically managed by a fund manager who selects investments based on the stated fund goal.

Investors can purchase a mutual fund to instantly diversify across several holdings but will pay an annual fee for holding the fund. Mutual funds may be less tax efficient because of how they are managed. Active funds, for example, may trade a lot and realize more capital gains.

Exchange-traded funds are very similar to mutual funds in that ETFs hold multiple securities within a single fund. Investors that purchase an ETF will pay a fee for holding the fund, but can get exposure to hundreds of investments.

Unlike mutual funds, ETFs can be actively traded during market hours and are treated more like stocks. Most ETFs offer hands-off management by just tracking a market index — which keeps capital gains and taxable events lower.

ETF vs. Mutual Funds: Tax Efficiency

In general, ETFs are more tax efficient than mutual funds in three ways:

1. ETFs buy and sell assets within the fund using “creation units”– meaning the fund will batch purchases and sales, and fewer taxable events occur with less transactions.

2. ETFs are generally passively managed and follow a market index, which also means fewer buying and selling transactions throughout the year. Mutual funds that are actively managed may cause more taxable events through buying and selling activities.

3. ETFs allow for in-kind redemptions, meaning they don’t have to sell an investment for cash and then use that cash to purchase another security but can trade one security for another.

Both mutual funds and ETFs are subject to taxes on dividends and capital gains when held in a taxable investment account.

Here’s how ETFs and mutual funds compare in each of these categories.

ETFs vs. Mutual Funds: Capital Gains Taxes

Capital gains taxes are a type of income tax that is reported when you sell an investment. If you’ve held the investment for less than one year, any gains are considered ordinary income. If you hold the investments for one year or longer, you’ll pay either 0%, 15% or 20%, depending on your tax bracket.

Selling a mutual fund or ETF in a taxable account will be subject to capital gains taxes at the same rate. However, since ETFs and mutual funds both hold a large range of investments, the fund manager may choose to sell individual securities within the fund, which could cause a taxable event.

In most cases, ETFs don’t actively buy and sell but simply track a market index — while mutual funds that are actively managed buy and sell securities much more often. And if the mutual fund manager chooses to sell investments that have risen in value, you’ll owe capital gains taxes on the transaction. This can make mutual funds much less tax efficient than investing with ETFs.

ETFs vs. Mutual Funds: Dividend Taxes

Both mutual funds and ETFs can pay out dividends, depending on the holdings within the fund. Dividends are paid by companies from excess profits to shareholders. If you hold any dividend-paying stocks within the ETF or mutual fund, you’ll receive those dividends based on the amount of stock you hold.

Dividends can also be paid out by bonds, REITs and other types of investments. Dividends are taxed at your ordinary income tax rate. For example, if you’re in the 24% tax bracket, your dividends may be taxed at that 24% rate. Both ETFs and mutual funds treat dividends the same, so it’s more about the types of investments within the fund that will determine if you pay more taxes for dividend income.

Costs and Trading Flexibility

Mutual funds and ETFs not only differ in their tax efficiency, but in fees and trading mechanics as well.

Mutual funds are not tradable during market hours, and trades are executed at the end of the trading day — 4:00 pm EST for the stock market. ETFs can be actively traded during market hours — 9:30 am to 4:00 pm EST — and give more flexibility to active traders and investors.

As for costs, mutual funds that are actively managed typically have much higher expense ratios than ETFs. This is because the fees pay for the fund manager and research department that helps manage the fund. Mutual fund fees can be up to 1% per year, which can take a bite out of your returns.

ETFs are typically much more cost efficient than mutual funds due to their passive managed nature. ETFs that track a market index don’t have teams of traders or research departments to pay for, and may charge only a fraction of the cost of a mutual fund. For example, Vanguard’s S&P 500 ETF (VOO) only charges 0.03% annually, as of Nov. 15, 2024. This can save investors money and increase overall fund performance.

Performance and Long-Term Considerations

Since ETFs are more tax-efficient and less expensive than mutual funds, they often perform better for investors. However, active mutual funds may outperform ETFs in specific market conditions or sectors, depending on their strategy.

ETFs are usually passively managed, and according to Morningstar, passive index funds typically outperform actively managed funds. Since many mutual funds are actively managed, passive index fund ETFs may outperform comparable active mutual funds.

But it’s not an apples-to-apples comparison, as some ETFs may outperform, and other mutual funds may perform better. It really depends on the underlying investments, fund fees, asset class, investing timelines and other factors.

As for tax efficiency, the small difference in how ETFs handle trades can net you less taxable income when holding an ETF in a taxable account. But the difference depends on how much you have invested and the type of fund chosen. It’s a good idea to review ETF or mutual fund prospectus to see how much “turnover” a fund expects to know if you’ll be hit with extra taxes.

When To Choose ETFs vs. Mutual Funds

In general, it might seem like ETFs are the better investment choice — and in many cases they might be — but you’ll want a deeper investment strategy in place before choosing one over the other. Here are a few scenarios to choose one over the other:

• If you’re a passive long-term investor, ETFs have lower costs and are more tax efficient, which may be a better choice.

• If you want a managed fund that actively tries to outperform benchmarks, a mutual fund may be a better choice.

• If you are an active trader, ETFs are the only fund options, as mutual funds cannot be traded while the market is open.

• If you want to know the exact holdings within a fund, ETFs offer more transparency by updating this information daily, while mutual funds only update quarterly.

• If you are holding investments in a taxable account, ETFs are more tax efficient.

Conclusion

In most cases, ETFs are more tax efficient than mutual funds but also offer lower fees and flexibility. ETFs can be traded during market hours and update holdings on a daily basis so investors always know exactly what’s in the fund. Mutual funds have been around much longer, and there are far more choices for investing strategies. But long-term investors who want to save on taxes and fees while growing their portfolio may want to choose ETFs over equivalent mutual funds.

FAQ

Here are the answers to some of the most frequently asked questions about ETFs vs. mutual funds.

• Is an ETF more tax-efficient than a mutual fund?

  • An ETF is more tax efficient than a mutual fund due to passive management and how the underlying investments are bought and sold. This means that ETF holders may have less capital gains tax to pay each year, while also paying less in annual fees for fund management.

• Are bond ETFs more tax-efficient than bond mutual funds?

  • Bond ETFs are more tax-efficient than bond mutual funds in how the underlying investments are bought and sold — and how the bond funds are managed. Actively-managed bond mutual funds may trigger a taxable event if the fund manager sells investments, while most bond ETFs are passively managed and don’t trade often.

This article originally appeared on GOBankingRates.com: ETFs vs. Mutual Funds Tax Efficiency: Understand the Key Differences