How ETFs Help You Cut Your Tax Bill

Exchange-traded funds can help you cut your tax bill.

Why it matters: All funds must distribute capital gains from the stocks and bonds that they sell throughout the year. The gains can leave you stuck with unwanted taxes. ETFs and mutual funds differ when it comes to tax efficiency. It starts with how the investments are traded and how the transactions are treated. The differences can result in ETF investors owing less than mutual fund investors or nothing at all because ETFs can minimize their capital gain distributions. Bryan Armour, Morningstar’s director of ETF and passive strategies research for North America, explains how ETFs beat mutual funds at the tax game.

14 Questions on ETF Tax Efficiency

1. ETFs are more tax-friendly than their mutual fund rivals. Why is that?
2. How does the way ETFs are traded limit the tax drag that affects mutual funds?
3. ETF investors will eventually pay a tax bill. Why is it important to control when that happens?
4. We talked about tax drag. What about cash drag? How are ETFs winning here?
5. An ETF’s underlying strategy can sharpen or dull the edge it has over a mutual fund when it comes to capital gains. Which ETF strategies have held the biggest advantage over the past few years?
6. Can you talk about the tax issues involving international stocks when managing gains in an ETF?
7. And what about taxable-bond ETFs versus mutual funds?
8. Some ETFs do not benefit from tax efficiency. Which investments are those, and why don’t they?
9. High-turnover strategies, where there’s a lot of buying and selling, can result in a big tax bill for investors. What have you found when you compared two momentum strategies?
10. How can outflows leave loyal investors with a big tax bill?
11. Active ETFs’ popularity is soaring. How tax-friendly are these investments versus their passive peers and mutual funds?
12. Which ETFs belong in taxable accounts and tax-advantaged accounts like an IRA or 401(k) to maximize tax efficiency?
13. What if someone listening or watching just realized they should work on their asset location? What should they do?
14. What’s the takeaway for using ETFs to cut tax bills?

Key Quote on ETF Tax Efficiency

Basically, you want that money compounding as long as you can before you actually pay the tax bill. If you take a capital gains distribution this year, for example, you receive that money, you pay taxes on it, then you put it back in a smaller amount. With the ETF, you wouldn’t have to pay until you sell it at the end of the day. That just allows you to compound. It’s a small return, but over long periods of time, it can be meaningful.

The Takeaway: Consider picking exchange-traded funds if you’re adding new money to a taxable account because of their extreme tax efficiency, says Armour. The investments rarely realize capital gains. Armour ran the numbers for 2024: Seven percent of US equity ETFs had capital gains distributions over 0%, while 78% of mutual funds did. Investment opportunities are likely to expand with more ETF share classes expected to arrive in the near future.

More From Morningstar on ETF Tax Efficiency

Loyalty is costing some faithful fund investors. Armour says significant outflows from mutual funds are forcing portfolio managers, who don’t have cash on hand, to sell their holdings and realize capital gains. And that’s increasing capital gains distributions. So, investors who are left behind are getting stuck with big tax bills. Read more about ETFs’ tax advantage over mutual funds and which strategies benefit.

Morningstar’s Lan Anh Tran explains how to solve the puzzle of maximizing the tax efficiency of an ETF portfolio. Morningstar’s Christine Benz writes about top tax-efficient ETFs for US and non-US equity and bond exposures. Check out Morningstar’s Guide to ETF Investing to get answers to some common questions, such as how many ETFs an investor should own.