ETFs vs. Mutual Funds: ETFs Have Tax Magic that Mutual Funds Don’t Offer; What Investors Should Know?
Investors have traditionally favoured exchange-traded funds due to their cost and flexibility. Less appreciated, perhaps, is one of the unique features that distinguish them from traditional mutual funds: tax efficiency. According to experts, “tax magic” can prevent ETF investors from facing the yearly tax bills typical of mutual fund holders, so ETFs look particularly attractive to taxable investment accounts.
Tax Efficiency: A Key Differentiator
ETFs and mutual funds are similar because they are both baskets of assets, such as stocks, bonds, or other financial instruments, managed by professionals. They do, however, differ in a more fundamental legal structure, which affords a distinct tax advantage for ETFs.
The source of this tax advantage lies in how ETFs pass capital gains to their shareholders. Mutual fund investors, of course, will experience capital gains taxes, as these occur when managers purchase and sell securities in the fund, passing them on to investors. But most mutual fund investors are hit with tax bills even if they reinvest those distributions.
In contrast, ETFs employ a process known as “in-kind creations and redemptions”, which allows for tax-free trading. This mechanism, involving major institutional investors known as “authorized participants,” creates very little in the way of taxes for ETF shareholders.
Stock Funds Tax Impact
The most significant tax difference can be seen in stock funds. Over 60% of the stock mutual funds distributed capital gains in 2023, compared with only 4% for ETFs. The trend is likely to continue this year, as less than 4% of ETFs are expected to distribute capital gains in 2024. Such low distributions show that ETFs can shield investors from taxable events.
When the Tax Advantage Matters?
This tax benefit is most crucial for investors holding ETFs in taxable accounts. Retirement accounts, such as 401(k)s or IRAs, already have intrinsic tax benefits, so the tax efficiency of an ETF has a lesser impact in such cases.
However, with taxable accounts, ETFs have an added advantage of tax efficiency that mutual funds cannot. Investors in these accounts are likely to appreciate the lower tax liabilities significantly which add to their long-term returns.
Exceptions to the Rule
Despite their many benefits, ETFs are not tax-efficient in all cases. Some assets in an ETF are not eligible for in-kind transactions, such as physical commodities and derivatives like swaps, futures contracts, and currency forwards. Furthermore, some countries, such as Brazil, China, India, South Korea, and Taiwan, tax in-kind redemptions, which can eliminate the tax advantages for securities held in those countries.
For investors in taxable accounts, ETFs are an attractive tax-efficient alternative to mutual funds, particularly for stock-based strategies. Their unique structure and the use of in-kind transactions offer a significant advantage in minimizing tax liabilities. Investors, however, need to be aware of the specific holdings within an ETF and the tax implications of international securities.
It’s possible to enjoy unmatched tax efficiency in taxable accounts by prudent ETF selection and tax implications for the investments. In fact, it is one of the most attractive features offered by ETFs.
