As investors consider fund options to fill out their investment portfolio, many have turned to exchange traded funds for the investment vehicle’s tax efficiency.

“Both ETFs and mutual funds typically hold a set of investments on your behalf. Yet, in many cases ETFs can be a smarter decision from a tax standpoint,” Simon Moore, Chief Investment Officer for Moola, said on Forbes.

ETFs Are More Tax Efficient

While both ETFs and mutual funds are subject to capital gains in a taxable investment account, ETFs are seen as more tax efficient than their older mutual fund counterpart due to so-called in-kind transfers. When mutual fund shares are sold, underlying assets are sold for cash, which may trigger a taxable event. On the other hand, ETFs undergo a kind of in-kind transfer of shares where a basket of underlying assets may be used to redeem or create ETF units. The in-kind process avoids cash sales and therefore does not trigger a taxable event.

“So, ETFs are generally a more tax efficient structure for investors, because ETFs can create and redeem units without it being a taxable event. This makes it possible for long-term holders of ETFs to see less ongoing capital gains, than holding similar assets within a mutual fund,” Moore explained.

However, potential investors should keep in mind that this tax benefit is mostly favorable for those with a taxable account. Mutual funds may be less tax-efficient than ETFs, but if an investor is holding mutual funds within a tax-advantaged structure such as a 401(k) or IRA, then differences in tax efficiency make very little difference.

For more information on investing in ETFs, visit our ETF 101 category.

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