Are ETFs tax-efficient relative to mutual funds?
ETFs are more tax-efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account.
From the perspective of the Internal Revenue Service, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and the ultimate tax bill – after the ETF is sold and capital gains tax is incurred – is less than what the investor would have paid with a similarly structured mutual fund. In essence, there are – in the parlance of tax professionals – fewer “taxable events” in a conventional ETF structure than in a mutual fund. Here’s why: A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment. In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure.
We are not tax advisors. You should always consult with your CPA before making any investment decision.