Tax Efficiency Differences: ETFs vs. Mutual Funds (2024)

Tax considerations for mutual funds and exchange-traded funds (ETFs) are similar in many ways; both are taxed on dividends and capital gains distributions as well as gains resulting from market transactions. However, due to their inherent structure, ETFs can often be more tax-efficient than mutual funds. Learn the differences between ETFs and mutual funds when it comes to tax efficiency.

Key Takeaways

  • Exchange-traded fund (ETF) and mutual fund capital gains resulting from market transactions are taxed based on whether the investment was held short-term or long-term.
  • Capital gains distributions from mutual funds (and ETFs on occasion) are taxed at the long-term capital gains rate.
  • Comprehensively, ETFs don't often have capital gains distributions, which makes them more tax-efficient than mutual funds.

ETF vs. Mutual Fund Tax Efficiency: An Overview

To understand the differences between tax considerations for ETFs and mutual funds, it helps to start with the basics for taxable investments.

The U.S. government requires a portion of nearly every type of income that an American receives. Therefore, while there are tax efficiencies to be considered, investors must plan on paying at least some tax on all dividends, interest, and capital gains from any type of investment unless designated tax exemptions apply.

There are some exemptions to taxation, such as Treasury and municipal securities. As such, an ETF or mutual fund in these areas would have tax-exempt characteristics.

Keep in mind there can also be some tax exceptions for both ETFs and mutual funds held in retirement accounts, as those are typically tax-advantaged accounts.

Capital Gains vs. Ordinary Income

Capital gains on most investments are taxed at either the long-term capital gains rate or the short-term capital gains rate.

ETF and mutual fund share transactions follow the long-term and short-term standardization of capital gains treatment. However, the one-year delineation does not apply to ETF and mutual fund capital gains distributions, which are when the fund manager sells some of the fund's assets for a capital gain and passes the earnings along. These are all taxed at the long-term capital gains rate. Capital gains distributions tend to be minimal for ETFs and are more associated with mutual funds.

Long-term capital gains refer to gains occurring from investments sold after one year and are taxed at either 0%, 15%, or 20% depending on the tax bracket. Short-term capital gains refer to gains occurring from investments sold within one year and are all taxed at the taxpayer’s ordinary income tax rate.


Dividends can be another type of income from ETFs and mutual funds. Dividends will usually be separated by qualified and non-qualified (ordinary), which each have different tax rates.

Overall, any income an investor receives from an ETF or mutual fund will be delineated clearly on an annual tax report used for reference in the taxpayer’s tax filing.

Oftentimes, investment advisors may suggest ETFs over mutual funds for investors looking for more tax efficiency. This advice is not a mere matter of the difference in taxes for ETFs vs. mutual funds, since both may be taxed the same, but rather a difference in the taxable income that the two vehicles generate due to their unique attributes.

ETF Taxes

ETFs are considered slightly more tax-efficient than mutual funds for two main reasons.

First, ETFs have a unique mechanism for buying and selling. ETFs use creation units that allow for the purchase and sale of assets in the fund collectively. This means that ETFs usually don't generate the capital gains distributions that mutual funds do, and therefore don't see the tax effects of those distributions.

Second, the majority of ETFs are passively managed, which in itself creates fewer transactions because the portfolio only changes when there are changes to the underlying index it replicates. Actively managed funds, in contrast, experience taxable events when selling the assets within them.

ETFs can be composed of many different types of securities, from stocks and bonds to commodities and currency. The U.S. Securities and Exchange Commission approved 11 new spot bitcoin ETFs in January 2024, broadening investor access to cryptocurrency via ETF.

Mutual Fund Taxes

Mutual fund investors may see a slightly higher tax bill on their mutual funds annually. This is because mutual funds typically generate higher capital gains due to the way they're managed.

Mutual fund managers buy and sell securities for actively managed funds based on active valuation methods, which allow them to add or sell securities for the portfolio at their discretion. Managers must also buy and sell individual securities in a mutual fund when accommodating new shares and share redemptions. These transactions typically pose a taxable event.

Fund Management and Taxation

The type of securities in a fund affects its taxation. Funds that include high dividend or interest-paying securities, regardless of whether they're an ETF or a mutual fund, will receive more pass-through dividends and distributions which can result in a higher tax bill.

Managed funds that actively buy and sell securities, and thus have larger portfolio turnover in a given year, will also have a greater opportunity of generating taxable events in terms of capital gains or losses. This is why mutual funds create a lot of capital gains distributions, especially in comparison to ETFs.

Other Advantages of ETFs Over Mutual Funds

ETFs have some additional advantages over mutual funds as an investment vehicle beyond tax efficiency.

  • Transparency: ETF holdings can be freely seen day-to-day, while mutual funds only disclose their holdings every quarter.
  • Greater liquidity: ETFs can be traded throughout the day, but mutual fund shares can only be bought or sold at the end of a trading day. This can have a significant impact on an investor when there is a substantial fall or rise in market prices by the end of the trading day.
  • Generally lower expense ratios: The average expense ratio for an ETF is less than the average mutual fund expense ratio.

Are ETFs More Tax Efficient Than Mutual Funds?

Generally, yes, ETFs are considered more tax efficient than mutual funds, as they tend to have fewer capital gains distributions and therefore fewer opportunities for taxation.

What Is the Tax Loophole for ETFs?

The so-called "tax loophole" for ETFs has to do with the wash-sale rule, which is the IRS rule prohibiting investors from selling an investment to claim the loss and then buying a "substantially identical" security to replace it in their portfolio. Because exchange-traded funds are typically based on an index and not a single stock, they avoid the "substantially identical" problem.

Do I Pay Taxes on an ETF if I Don’t Sell?

It depends. You may need to pay taxes if the ETF holds dividend-paying stocks or interest-yielding bonds, even if you're holding on to the ETF for the long-term.

The Bottom Line

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Tax Efficiency Differences: ETFs vs. Mutual Funds (2024)


Tax Efficiency Differences: ETFs vs. Mutual Funds? ›

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

Are ETFs really more tax-efficient than mutual funds? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Do ETFs have better returns than mutual funds? ›

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often.

Are ETFs more cost effective than mutual funds? ›

With all things being equal—the structural differences between the 2 products give ETFs a cost advantage over mutual funds. For the most part, ETFs are less costly than mutual funds.

Are mutual funds taxed differently? ›

Mutual fund taxes typically include taxes on dividends and earnings while the investor owns the mutual fund shares, as well as capital gains taxes when the investor sells the mutual fund shares. The tax rate (and in turn the tax on mutual funds) depends on the type of distribution and other factors.

Why are ETFs more tax-efficient than funds? ›

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

Why do ETFs outperform mutual funds? ›

Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.

Why would I buy a mutual fund instead of an ETF? ›

Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Should I switch my mutual funds to ETFs? ›

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

Do you pay taxes on ETFs if you don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Why are ETFs more risky than mutual funds? ›

The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.

Which of the following funds are usually most tax-efficient? ›

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.

Why are mutual funds not tax-efficient? ›

Mutual funds with dividend distributions can bring in extra income, but they are also typically taxed at the higher ordinary income tax rate. In certain cases, qualified dividends and mutual funds with government or municipal bond investments can be taxed at lower rates, or even be tax-free.

How to avoid tax on mutual funds? ›

Systematic Withdrawal Plan (SWP): Set up an SWP to automatically redeem your mutual fund units regularly. By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether.

Do you get double taxed on mutual funds? ›

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.

How are ETFs so tax-efficient? ›

By minimizing capital gains distributions, ETF tax efficiency lets investors defer tax bills until they sell shares, preserving more capital for market investment and potential compounded returns over time.

Which ETF is most tax-efficient? ›

Top Tax-Efficient ETFs for U.S. Equity Exposure
  • iShares Core S&P 500 ETF IVV.
  • iShares Core S&P Total U.S. Stock Market ETF ITOT.
  • Schwab U.S. Broad Market ETF SCHB.
  • Vanguard S&P 500 ETF VOO.
  • Vanguard Total Stock Market ETF VTI.

Are actively managed ETFs tax-efficient? ›

As you can see, active ETFs offer significantly greater tax efficiency than actively-managed mutual funds in three of the four asset classes we investigated. The results are especially dramatic for large and small cap equity funds where active ETFs deliver the largest reductions in taxes.

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