One major benefit of an ETF is the tax advantage it holds over a mutual fund. To understand why ETFs are more tax-efficient than mutual funds, you have to understand two things: capital gains tax and the construction of these two different financial products.
To put it simply, ETFs hold tax advantages over mutual funds because the underlying assets are traded less frequently and individual investors can choose when to trigger those taxes by actualizing the gains.
Still confused? Keep reading for a deeper explanation of these concepts.
Capital Gains Tax
Whenever you sell an asset for a profit, the government wants its share of the sale. The tax on this profit is known as the capital gains tax. If you make money, the government makes money.
However, not all profit is treated equally by the Internal Revenue Service (IRS). The primary determinant of your capital gains tax rate is how long you hold the security. If you hold a stock for a year or less before selling it for a profit, then your profit will be taxed at the same rate as your income tax rate. If you hold the stock for more than a year, then your gains are taxed at a special "long-term capital gains" rate.
The exact rate you'll pay on long-term capital gains will still depend on your income tax bracket, but it'll almost certainly be more favorable than your income tax rate.
Mutual Funds Trade Holdings More Frequently
Most mutual funds are actively traded. Every time someone buys into the fund, the fund manager uses that cash to buy more shares. Every time someone sells off some of their mutual fund shares, the fund manager needs to sell holdings to acquire the cash to pay the person for the shares they're selling.
Every time this happens, and equities are sold for a profit, capital gains taxes must be paid. Over time, all these frequent tax incursions can add up. Investors can't choose which shares are sold, either, so they can't control whether the capital gains are short-term or long-term.
ETFs function much differently. Many popular index ETFs are passively managed. The ETF's underlying holdings are reassessed less often, such as once per quarter. When those holdings are reassessed, they are rebalanced to ensure they still reflect the index they are tracking. In many cases, this rebalancing chiefly concerns which shares to buy more of, rather than which shares to sell.
Furthermore, ETF managers don't need to buy or sell securities every time an investor buys or sells a share of an ETF. That's because, as opposed to mutual funds, ETF shares are traded directly between investors. The seller trades the ETF shares directly to the buyer, rather than going through the ETF manager.
The ETF manager ensures that the share price reflects the value of the underlying holdings with the help of institutional forces known as "authorized participants." Authorized participants only trade in bulk amounts — typically 25,000 shares or more — so there isn't a need to trade underlying ETF holdings every time an investor sells a single share.
Investors Control the Timing of ETF Taxes
While the underlying shares of an ETF are traded less frequently, they are still traded and capital gains taxes do apply. However, there's a major difference with ETFs, as far as the IRS is concerned: the capital gains taxes are only paid by investors when the entire ETF sold. You will never pay taxes on ETF shares while you hold them.
Mutual funds, on the other hand, usually distribute capital gains taxes annually. Throughout the year, the mutual fund manager will track the capital gains taxes, along with things like dividend payments and capital gains profits. At the end of the year, those odds and ends are distributed to investors in proportion to the number of mutual fund shares they own.
Mutual fund investors may not notice the taxes since they can be distributed at the same time as dividends, but they're there. You're being taxed, even if you didn't personally sell any mutual fund shares during the year.
Since ETF investors only pay capital gains taxes when they personally sell their shares, they can control when to impose the taxes on themselves. They can use timing strategies to impose these taxes when it's beneficial. While they wait for the perfect time to impose the taxes, their equity enjoys compound gains from tax deferral.
Dividend Taxes Will Apply to ETF Investors
Things are a little different when it comes to taxes on ETF dividends. Rather, things are the same as with other investments, because ETFs don't enjoy special dividend tax treatment.
Whether you own a single stock, an index ETF, or a high-dividend ETF, dividends will typically end up in your brokerage account as cash. Since you are being paid out in cash, you can expect to pay taxes on it. You won't get any special tax breaks for receiving the dividend from an ETF.
While on the topic of dividend taxes, it's worth noting that the IRS classifies dividends in two ways: qualified and ordinary. You can think of qualified dividends the same way you think of long-term capital gains because they both receive preferred tax treatment. Like long-term capital gains, dividends become "qualified" when an investor holds the security for a longer period (more than 60 days). In most cases, the dividend also needs to come from a U.S. company to be a qualified dividend, though certain foreign companies issue qualified dividends.
An ETF investor can ensure that they've held the ETF for more than 60 days, but they can't ensure that the ETF manager is holding the underlying securities for more than 60 days. Therefore, ensuring that dividends from ETFs are qualified isn't as simple as ensuring that dividends from individual stocks are qualified.
The Bottom Line
An ETF holds two major tax advantages over a mutual fund. First, mutual funds usually incur more capital gains taxes due to the frequency of trading activity. Secondly, the capital gain tax on an ETF is delayed until the sale of the product, but mutual fund investors will pay capital gains taxes while holding shares.
Keep in mind that these advantages are not just limited to ETFs, but ETNs (exchange-traded notes), as well. ETNs are similar products to ETFs, but it's important to understand all the implications of investing in any product before placing a trade.