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The tax implications of ETFs vs. mutual funds

Whether you’re a financial aficionado, an economic experimenter, or have recently taken an interest in investments, it’s hard to deny that investing can be exciting and empowering. It allows you to take control of your financial future, potentially generate passive income, and pursue your financial goals. And you don’t have to be well-versed in Wall Street jargon to geek out over that.

But before you get to the fun part, it’s important to understand the costs of your investments. This includes things like fees, commissions, minimum deposit requirements — and taxes.

Different types of investments can have different tax implications for you, and you might have heard that some are more tax efficient than others — meaning they may have fewer tax liabilities. For example, exchange-traded funds (ETFs) are one type of investment that may be a tax-efficient choice for you.

If you’re wondering why that is, read on to learn about ETF tax efficiency.

The basics of ETFs

ETFs pool together money from numerous investors to invest in a basket of underlying securities. The securities held within an ETF may be equities, bonds, options , or other asset classes (or a mix of different types).

Typically, ETFs are passively managed. That’s because they usually track an index (like the S&P 500) and all the holdings within the fund are replicated from that index. An equity ETF may also track an industry (like biotech), meaning such an ETF's holdings generally comprise equities issued by businesses within that sector.

As an investor, you trade ETFs throughout the day on an exchange, similar to stocks. Because they can be bought and sold any time while the market is open, the market price of an ETF may fluctuate during the day, unlike mutual funds, which are only priced once at market close based on their net asset value (NAV).

Do I need to pay taxes on ETFs?

In short: yes. With the exception of a few tax-exempt securities, you are required to pay taxes on almost every type of income. That means you can expect to have a tax bill on earnings from dividends, capital gains, or interest for any kind of investment — from stocks to open-end funds to ETFs.

What am I being taxed on?

When it comes to ETFs (as well as mutual funds), earnings from dividends and capital gains are considered taxable income. This includes the interest income you can earn on ETFs, including those whose underlying securities are bonds.

Dividends are regular payments of a company’s profits that are distributed to shareholders, typically quarterly (though you can find the exact dividend date within an ETF’s prospectus). An ETF may distribute dividends if its underlying stocks pay dividends.

Capital gains are realized by an ETF when a security held within a fund’s portfolio increases in value and is then sold by the fund manager. If a mutual fund or ETF incurs capital gains, the fund generally must distribute them by year’s end to shareholders, who are then responsible to pay taxes on those gains.

Taxes on ETFs vs. mutual funds

As we mentioned previously, ETFs and mutual funds are subject to the same tax treatment by the Internal Revenue Service (IRS). So, what makes ETFs different and potentially more tax efficient? The answer lies in the inner workings of the two types of funds.

ETFs can be more tax efficient than mutual funds because they traditionally experience fewer taxable events. This is due in part because index-tracking ETFs often don’t have a lot of turnover of individual holdings, unless the underlying index changes.

ETFs also use a different system for the creation and redemption of shares than mutual funds. When a large bank or financial institution called the authorized participant (AP) wants to redeem shares of an ETF, the ETF exchanges the shares for underlying holdings of the ETF itself. Since there is no cash involved, this in-kind trade doesn’t trigger the realization of capital gains.

Mutual funds, on the other hand, have to constantly buy and sell securities to rebalance the fund and accommodate shareholder redemptions. These trades are based on the fund manager’s discretion.

Keep in mind, however, you are subject to the capital gains tax if you earn a profit from trading your individual ETF shares (i.e. selling for a higher market price than you paid). You’ll either pay long-term or short-term capital gains taxes, depending on whether you held the asset for at least one year or less than a year.

Could ETF trading be right for you?

ETFs could provide a number of benefits as  part of your investment strategy. Aside from being built to help individual traders like you potentially avoid certain tax implications, these investments can help you diversify your holdings across industries, countries, and other assets classes — helping you to create a more balanced portfolio.

Whether you like to handle your own ETF trading or prefer the support of a financial advisor, we have options for you, including hundreds of commission-free ETFs though our Self-Directed Trading platform, as well as Robo Portfolios built with a diverse mix of ETFs that fit your goals.

No matter which investment avenue you take, your unadulterated excitement about investing might cause you to jump feet first into the ETF marketplace. (Is there anything more fun than cannonballing into a swimming pool?) But taking the time to read the prospectus of your potential ETF investment to understand the associated expenses, fees, and taxes — maybe even consulting a tax professional with further questions — can save you from some big surprises down the road, especially when Uncle Sam comes knocking.

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