Both ETFs and mutual funds typically hold a set of investments on your behalf. Yet, in many cases ETFs can be a smarter decision from a tax standpoint, we’ll explain why.
First off, there are many reasons to hold ETFs and mutual funds, especially now various funds are extremely cheap with even a few funds being available for free. However, here we are only going to focus on the tax issues for ongoing holders of these funds, not the other costs, such as expense ratios.
If you hold an investment in a taxable account, then if an investment makes money and you sell it, you will typically owe capital gains on that price increase. For example, if you buy one share at $30 and sell at $50, then you’ll have a gain of $20 that you’ll most probably owe tax on. This normally doesn’t matter for tax-sheltered accounts such as IRAs and 401(k)s, since these sorts of investment vehicles are sheltered from capital gains, and various other investment taxes. Yet, for taxable accounts, taxes can eat into returns, especially in good markets.
When you buy or sell a mutual fund, the capital gains situations are very similar. You own a mutual fund and it rises in value, then when you sell it you likely have to pay tax on that gain. The same is true of ETFs. So don’t get confused, if you buy either type of fund, in a taxable account and it makes money for you, then when it comes time to sell you’ll probably owe taxes. ETF or mutual fund, it doesn’t matter. That’s one reason why low turnover strategies where you trade less, can work out to be more tax-efficient.
However, the key tax benefit from ETFs comes from in-kind transfers. When shares in a mutual fund are sold, the underlying assets is typically sold for cash, this may create a capital gain if that particular share in the fund has risen in value. Of course, many mutually funds are expertly managed from a tax standpoint, but at some point tax is inevitable. For an ETF when an investor wants to sell shares they can ultimately be redeemed in kind with authorized participants who create and redeem ETF units. This process generally avoids any cash sales and therefore, makes ETFs extremely tax efficient.
The Vanguard patent
Some time ago, Vanguard patented making ETFs a separate share-class of their mutual funds. This potentially means that the tax-efficient benefits of the ETF can be shared with the mutual fund, and both benefit from the scale involved in pooling assets. As such though in most cases mutual funds can be less efficient than mutual funds that may not always be the case for Vanguard products. However, that patent may expire in the next few years, in which case the advantage that Vanguard has on ETF design may be accessible to other fund issuers. There have also been some rumors that Vanguard explored licensing this patented structure to other fund providers, but it’s unclear they ever did.
Why ETFs win
So, ETFs are generally a more tax efficient structure for investors, because ETFs can create and redeem units without it being a taxable event. This makes it possible for long-term holders of ETFs to see less ongoing capital gains, than holding similar assets within a mutual fund. However, this benefit only applies during the period when you hold an ETF. If you own an ETF and then sell it, your capital gain on that sale will likely be very similar to as if you had bought and sold the same mutual fund. However, it is fairly likely that the mutual fund may have passed capital gains on to you along the way while you held the investment. Also, this only matters for taxable accounts, mutual funds may be less tax-efficient, but if you’re holding them within a tax-advantaged structure like a 401(k) or IRA, then differences in tax efficiency make very little difference to you.