Measuring ETFs' Tax Efficiency Versus Mutual Funds
ETFs' structure makes them more tax-efficient than their mutual fund counterparts.
Exchange-traded funds tend to be more tax-efficient than mutual funds, chiefly because they tend to distribute fewer (if any) and smaller capital gains. ETFs’ tax efficiency has been a key selling point for tax-sensitive investors who prefer greater control over the timing and magnitude of the capital gains bills from the funds in which they invest.
Exchange-traded funds' tax efficiency should not be conflated with tax immunity. Investors in ETFs will still pay taxes on regular distributions of income, and they will be on the hook for capital gains taxes when they sell an ETF for more than they paid for it. Also, some ETFs will distribute capital gains, though they tend to be less frequent and of lesser magnitude than those their mutual fund counterparts generate. So, while ETFs are more tax-efficient--thanks mostly to their unique structure and with some help from their underlying strategies--they are not immune to taxation. Their primary benefit from a tax perspective is that they can allow investors to defer the realization of capital gains taxes.