Why ETFs Are a Tax Efficient Investment Vehicle

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.