ETFs vs. mutual funds: Tax efficiency

ETFs can be 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 IRS, 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.

Taxable events in ETFs

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.

To be fair to mutual funds, managers take advantage of carrying capital losses from prior years, tax-loss harvesting, and other tax mitigation strategies to diminish the import of annual capital gains taxes. In addition, index mutual funds are far more tax efficient than actively managed funds because of lower turnover.

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ETF capital gains taxes

For the most part, ETF managers are able to manage the secondary market transactions in a manner that minimizes the chances of an in-fund capital gains event. It's rare for an index-based ETF to pay out a capital gain; when it does occur it's usually due to some special unforeseen circumstance.

Of course, investors who realize a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%. These percentages are based upon your taxable income and—depending on your modified adjusted gross income (AGI)—you might have to pay an additional 3.8%. The important point is that the investor incurs the tax after the ETF is sold.

Taxation of ETF dividends

ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor’s income tax rate. If the dividend was held less than 60 days before the dividend was issued, then the dividend income is taxed at the investor’s ordinary income tax rate. This is similar to how mutual fund dividends are treated.

Exceptions to the rules

Certain international ETFs, particularly emerging market ETFs, have the potential to be less tax efficient than domestic and developed market ETFs. Unlike most other ETFs, many emerging markets are restricted from performing in-kind deliveries of securities. Therefore, an emerging-market ETF might have to sell securities to raise cash for redemptions instead of delivering stock. This sale would cause a taxable event and subject investors to capital gains.

Leveraged/inverse ETFs have proven to be relatively tax-inefficient vehicles. Many of the funds have had significant capital gain distributions on both the long and the short funds. These funds generally use derivatives—such as swaps and futures—to gain exposure to the index. Derivatives cannot be delivered in kind: They must be bought or sold. Gains from these derivatives generally receive 60/40 treatment by the IRS, which means that 60% are considered long-term gains and 40% are considered short-term gains regardless of the contract's holding period. Historically, flows in these products have been volatile, and the daily repositioning of the portfolio to achieve daily index tracking triggers significant potential tax consequences for these funds.

Commodity ETPs have a similar tax treatment to leverage/inverse ETFs because of the use of derivatives and the 60/40 tax treatment. However, commodity ETPs do not have the daily index tracking requirement or use leverage/short strategies, and they have less volatile cash flows simply due to the nature of the funds.

Exchange traded notes (ETNs)

The most tax efficient ETF structure are exchange traded notes. ETNs are debt securities guaranteed by an issuing bank and linked to an index. Because ETNs do not hold any securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN. ETN shares reflect the total return of the underlying index; the value of the dividends is incorporated into the index's return, but are not issued regularly to the investor. Thus, unlike with many mutual funds and ETFs that regularly distribute dividends, ETN investors are not subject to short-term capital gains taxes. But like conventional ETFs, when the investor sells the ETN, they are subject to a long-term capital gains tax.

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Article copyright 2011-2023 by David J. Abner and Gary L. Gastineau. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange-Traded Funds and The Exchange-Traded Funds Manual, Second Edition with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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