Which is more tax efficient ETF or index fund?
Because index funds buy and sell stocks so infrequently, they rarely trigger capital gains taxes for investors. When it comes to tax efficiency, ETFs have the edge. Unlike index funds, ETFs rarely buy or sell stock for cash.
ETFs owe their reputation for tax efficiency primarily to passively managed equity ETFs, which can hold anywhere from a few dozen stocks to more than 9,000. Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
There are typically no shareholder transaction costs for mutual funds. Costs such as taxation and management fees, however, are lower for ETFs. 2 Most passive retail investors choose index mutual funds over ETFs based on cost comparisons between the two. Passive institutional investors tend to prefer ETFs.
ETFs. Like index funds, exchange-traded funds (ETFs) are passively managed, which makes them more tax efficient than actively managed mutual funds. Also, ETFs are structured in a way that doesn't generate capital gains taxes when securities are bought and sold. Investors do pay capital gains tax when they sell shares.
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.
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.
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.
Tax strategy
If you buy and sell frequently, ETFs are the clear winner when it comes to taxes. When shares of an ETF are sold, only the seller pays capital gains taxes. That's different from index mutual funds because you sell these shares to a fund manager.
ETFs and mutual funds that track an index typically have lower management fees than actively managed ETFs or mutual funds. A mutual fund is priced once a day and all transactions are executed at that price, while the price of an ETF fluctuates throughout the day as it is bought and sold through an exchange.
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
What is the ETF tax loophole?
Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.
| Tax Saving Options | Returns* | Lock-in Period |
|---|---|---|
| Unit Linked Insurance Plan (ULIP) | 11% to 20% p.a. (depending on the chosen plan) | 5 years |
| Sukanya Samriddhi Yojana (SSY) | 8% p.a. | 21 years |
| Public Provident Fund (PPF) | 7.1% p.a. | 15 years |
| Employee Provident Fund (EPF) | 8.15% p.a. | 5 years |
For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
- Invest for the Long Term.
- Take Advantage of Tax-Deferred Retirement Plans.
- Use Capital Losses to Offset Gains.
- Watch Your Holding Periods.
- Pick Your Cost Basis.
Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
- 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.
In many ways mutual funds and ETFs do the same thing, so the better long-term choice depends a lot on what the fund is actually invested in (the types of stocks and bonds, for example). For instance, mutual funds and ETFs based on the S&P 500 index are largely going to perform the same for you.
All mutual funds, including index funds, are required to pay out any realized gains to shareholders on a pro-rata basis at least once a year. Typically, actively managed equity mutual funds do so annually in the form of short-term and long-term capital gains.
Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.
What happens if ETF goes bust?
So if an ETF provider goes bankrupt, your investments are not gone cause they will still be kept by the custodian. This separation is imposed by the European regulatory framework that governs financial services. In the event of a bankruptcy, another provider will then take over management of the fund.
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 VFIAX, a mutual fund, and SPY, an ETF, seek to track the S&P 500. The SPY ETF may have a slight tax advantage over the VFIAX mutual fund since it's not actively managed, meaning there's less buying and selling of trades. VFIAX and SPY are generally considered strong investments, especially for passive investors.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
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.
