Exchange-traded funds, or ETFs, are popular investment vehicles, and while they may generate returns for investors, they can also offer certain tax advantages. That’s particularly true when comparing ETFs to other, similar investment types, such as mutual funds.
That does not, however, mean that there are some critical things to know about tax efficiency and ETFs. There are a lot of factors and variables to take into consideration when devising your investment strategy, so it’s worth knowing the details about what makes an ETF advantageous, in some cases, for tax reasons over mutual funds.
Key Points
• ETFs may offer tax advantages over mutual funds by reducing capital gains and minimizing taxable events.
• ETFs use ‘creation units’ to trade large blocks of shares, enhancing tax efficiency.
• Dividends and high trading costs in actively managed ETFs may offset some tax benefits.
• Actively managed ETFs tend to have higher trading costs due to the frequent trading needed to meet investment goals.
• ETFs generally have fewer capital gains, lower fees, and less frequent trading, making them more tax-efficient.
ETFs & Mutual Funds: How They Differ
When it comes to understanding ETFs vs mutual funds, it’s often best to start with a simple explanation for each.
Both mutual funds and ETFs invest in a group or “basket” of underlying stocks, bonds, commodities, and other financial assets, on behalf of fund shareholders. But ETFs trade on a daily basis, much like stocks and bonds. Mutual funds do not.
Mutual funds offer investors a menu of various share classes where they can invest their money. Given the wider selection of assets available, a mutual fund investor may see more fund fees to compensate for that expanded menu. Given their low trading structure, ETF fees are usually lower than those of mutual funds, often resulting in a lower expense ratio.
ETF Tax Advantages Over Mutual Funds
Tax-wise, the IRS treats ETFs and mutual funds the same. When an investor who owns either fund type sells securities that have appreciated in value, it creates a capital gain — or capital appreciation on the investment — which is taxable under U.S. law. The same is true if they’re selling at a loss as well — selling the asset triggers a taxable event.
ETF fund managers make trades for a variety of reasons. For example, an asset can be bought and sold for strategic reasons (i.e., to properly allocate assets or to avoid “style drift” when a fund slides away from its target strategy). Trades also must be made upon shareholder redemptions — when they redeem some or all of the assets they’ve invested in the fund.
The more trades made by ETF fund managers, the more taxable events occur. Consequently, for fund managers and investors, the goal is to find ways to keep those taxes from accumulating.
An ETF’s structure can help curb the negative impact of taxes in the following ways.
Lower Capital Gains Impact
Since the IRS considers capital gains a taxable event, a major goal with any fund investment is to reduce the impact of capital gain payouts to shareholders at year-end.
ETFs typically accumulate fewer capital gains than mutual funds. When a mutual fund has to redeem assets back to shareholders, it must sell assets to create the money needed to pay out those redemptions, resulting in capital gains. But when an ETF shareholder wants to sell shares, they can easily do so by trading the ETF to another investor, just like a stock transaction. That, in turn, creates no capital gains impact for the ETF, and adds a major tax advantage for ETF investors.
Index Tracking Tax Benefits
Since many ETFs are structured to track a particular index, trades are made only when there are changes in the underlying index (like when the S&P 500 or the Russell 2000 index experience significant fluctuations that require some ETF stabilization). Fewer transactions generally means lower taxes.
The Use of “Creation Units”
ETFs are built to trade differently than mutual funds. With ETFs, fund managers can leverage so-called “creation units” — blocks of shares — to buy and sell fund securities. These units enable fund managers to buy or sell assets collectively, instead of individually. That means fewer trades and fewer taxable trade execution events.
Downsides of ETFs and Taxes
Though ETF tax efficiency is generally better than that of mutual funds, that doesn’t mean ETFs come with no tax risks. There are a few taxable events that bear watching for investors.
Distributions and Dividends
Just like any investment vehicle, ETFs can come with regular distributions and dividends, which are usually taxable.
Increased Trade Activity on Actively Managed Funds
Though most ETFs simply follow an investment index, there are some actively managed ETFs. With actively managed funds, more trades are made, which may lead directly to a more onerous tax bill.
Trading Costs
Since ETFs are traded like stocks, the fees that come with buying and selling ETF assets usually trigger trading costs that are akin to trading stocks, and those fees can be high. Historically, brokerage trading fees are among the highest fees in the investment industry, which isn’t great news for ETF investors. Even if investors do save on taxes, those savings can potentially be mitigated or even wiped out by high ETF trading costs.
The Takeaway
Exchange-traded funds offer ample potential tax benefits to savings-minded investors, especially in key areas like capital gains, expense ratios, redemptions, and trading frequency. That does not mean there aren’t potential downsides, however, that could include taxable dividends or distributions, higher potential trading costs, and more.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
What are the advantages of ETFs over mutual funds?
While similar, ETFs tend to have lower associated fees than mutual funds, and depending on their structure, ETFs may also yield specific tax advantages, too.
What are the differences between ETFs and mutual funds?
Both mutual funds and ETFs invest in a group or “basket” of underlying stocks, bonds, commodities, and other financial assets, on behalf of fund shareholders. But ETFs trade on a daily basis, much like stocks and bonds. Mutual funds do not, and tend to offer investors a wider variety of investing options–in addition to higher fees.
What are some potential tax-related disadvantages of ETFs compared to mutual funds?
Potential tax-related disadvantages of ETFs, as they relate to mutual funds, can include taxable distributions and dividends, higher tax liabilities related to more trading activity, and potentially, higher trading costs.
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
¹Claw Promotion: Probability of Member receiving $1,000 is a probability of 0.026%; If you don’t make a selection in 45 days, you’ll no longer qualify for the promo. Customer must fund their account with a minimum of $50.00 to qualify. Probability percentage is subject to decrease. See full terms and conditions.
Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®
SOIN-Q225-036