As we’re moving closer to the end of the year, mutual fund investors will notice a tax hit on capital gains. However, due to the way the investment vehicle is structured, exchange traded funds will avoid taxable gains.
Unlike mutual funds, ETFs do not sell holdings in exchange for cash, which would trigger a taxable event. ETFs are more tax efficient than their mutual fund counterparts because of “in-kind” creation and redemption of shares.
Throughout the day, ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa. [In-Kind Creations and Redemptions]
Investors should be aware that an index-based ETF can pay out a capital gain, but it is usually due to some rare circumstance. Most would typically incur a long-term capital gains tax on an ETF when the investment is sold in a taxable account. [How Low-Cost ETFs Can Help Boost Your 401(k) Returns]
In contrast, mutual fund managers need to constantly re-balance the fund by selling securities to make up for redemptions or to re-allocate assets, according to Fidelity.