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ETFs and Tax Efficiency: What You Need to Know

Exchange traded funds (ETFs) are inherently tax-efficient investment vehicles, thanks to their capacity to effect in-kind creation and redemption transactions and investors’ ability to trade shares on the secondary market.

4 min read

For investors focused on maximizing after-tax returns, it’s important to understand how ETFs are taxed and how their structure can help you minimize taxes.

Why Are ETFs Tax Efficient?

Tax efficiency refers to how well an investment minimizes an investor’s taxes during the holding period. ETFs typically generate low capital gains tax liabilities from distributions for four reasons:

1. Low Portfolio Turnover

ETFs tend to have low turnover, which can reduce the realized gains that need to be distributed. Of course, different ETFs have different levels of internal turnover, so it’s important for investors to review a fund’s prospectus.

2. More Long-term Capital Gains

Low turnover often means a longer holding period for each of the underlying investments. ETFs generally hold underlying securities longer than 12 months, which usually qualifies any gains that are realized for favorable long-term capital gains tax rates.

3. Secondary Market Transactions

When ETF investors sell their shares on the stock exchange to other investors, the ETF portfolio manager does not need to buy or sell any of the ETF’s underlying investments. As such, one ETF investor’s sell decision has no impact on other investors, helping to keep capital gains distributions low.

4. Primary Market Transactions

ETFs have a unique creation and redemption mechanism — allowing authorized participants (APs) to build baskets of ETF shares when demand increases (creation) or disassemble the baskets of ETF shares back into single securities should demand decrease (redemption). This happens in the primary market.

Primary market creation and redemption transactions are typically conducted in-kind, meaning securities are exchanged for ETF shares, rather than for cash. These in-kind transactions do not trigger a taxable event for the fund, helping to improve the tax efficiency of ETFs.

ETFs Are More Tax Efficient Than Mutual Funds

While both ETFs and mutual funds must distribute any capital gains to shareholders at the end of each year, decreasing their return on investment, ETFs generally distribute fewer capital gains than mutual funds.

The improved tax profile for ETFs is a result of the tax-efficient, in-kind redemption process used to meet shareholder redemptions described above.

Additionally, the ability for investors to transact with each other in the secondary market when buying or selling ETF shares reduces the number of primary market transactions (creation/redemptions) needed for ETFs, especially for the small number of ETFs that cannot deliver all securities in-kind (e.g., some active fixed income strategies and certain securities within emerging market funds).

Mutual funds are not structured to support this tax efficiency. Because mutual fund investors interact only with a fund, all inflows and outflows are in the form of cash — not with the underlying securities like ETFs. As a result, when mutual funds have redemptions, fund managers must sell securities to raise cash to meet the redemption, creating a possible capital gains event for all shareholders.

The difference in capital gains distributions between ETFs and mutual funds is staggering. In 2022, just 4% of all ETFs distributed capital gains compared to 44% of mutual funds.1

ETF Structure Influences Taxation

There are multiple ETF structures, often determined by how the product gains exposure to the underlying asset. The cross-section of structure and underlying asset can impact the tax implications. For example:

  • ETFs backed by physical metals (such as gold and silver) may be treated as collectibles for tax purposes and carry a higher top federal long-term capital gains tax rate than other investments.
  • Commodity ETFs using futures contracts are often structured as limited partnerships. These ETFs may be subject to the “60/40” rule, whereby 60% of the capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss, regardless of the actual holding period.
  • Currency ETFs are sometimes structured as grantor trusts, which means all distributions and gains may be taxed as ordinary income.
  • Leveraged/inverse ETFs may have high turnover and use derivatives that may receive 60/40 tax treatment.

Prior to investing in any ETF, be sure to consider your overall investment objectives and review the prospectus for important information about the potential tax bill.

Taxes on ETF Distributions

It’s important to recognize that ETFs can have tax consequences. Distributions are typically paid out monthly, quarterly, semiannually, or annually. Distributions come from multiple sources, which impacts how they are taxed:

ETF Distribution Type Description General Tax Framework
Dividends Distribution of dividends from underlying stock holdings

ETFs can designate certain dividends as “qualified,” which means they qualify to be taxed at favorable capital gains rates. To be qualified, dividends must meet certain holding period criteria.

Non-qualified dividends are taxed at ordinary income tax rates.

Interest Income Distribution of interest generated by underlying fixed income holdings At the federal level, income from taxable bond ETFs is generally taxed at ordinary income tax rates.
Capital Gains Distribution of capital gains generated when the fund manager buys and sells securities, often due to index rebalancing or to meet diversification requirements ETFs will account for how gains and losses are generated and report which portion is attributable to long-term capital gains and short-term capital gains.
Return of Capital (Non-dividend Distribution) Distribution in excess of an ETF's earnings Returns of capital are not immediately taxable; these distributions aren't income or profits, but rather a return of an investor's money.

Use ETFs as tax swaps when tax loss harvesting. When stocks or bonds decline in value, you may be able to harvest those losses to offset capital gains elsewhere. Get the rules here.

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