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.
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.
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:
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.
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.
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.
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.
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
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:
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.
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.
Visit our ETF Education Hub to explore other ETF topics.
1 Morningstar, as of May 25, 2023. Calculations by SPDR Americas Research. Based on oldest share class.
Authorized Participant (AP)
A US-registered and self-clearing broker-dealer who meets certain criteria and signs a participant agreement with a particular ETF sponsor or distributor to become an “authorized participant” of the fund. APs are often associated with large and influential investment banks, and are scrutinized for their integrity and operational competence as they are the only parties who transact directly with an ETF.
Creation and Redemption Process
The process whereby an ETF issuer takes in and disburses baskets of assets in exchange for the issuance or removal of new ETF shares.
The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity.
The market where shares of an ETF are created or redeemed.
A market where investors purchase or sell securities or assets from or to other investors, rather than from issuing companies themselves. The New York Stock Exchange and the NASDAQ are secondary markets.
Important Risk Information
Frequent trading of ETFs could significantly increase commissions and other costs, such that they may offset any savings from low fees or costs.
These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities.
Investing involves risk, including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Diversification does not ensure a profit or guarantee against loss.
There can be no assurance that a liquid market will be maintained for ETF shares.