ETFs and mutual funds are two forms of investments that are widely used. When comparing the two there is one standout benefit that ETFs have over mutual funds – their tax efficiency. What separates these two investments’ tax implications is that they are structured and traded differently.
ETFs are index funds whereas mutual funds tend to be actively managed. A majority of the time ETFs create fewer taxable events due to the fact that their funds are not sold until there is a change in their index. Since theses funds are traded on exchanges, shareholders do not have to liquidate any of the holdings. As a result of less liquidation the shareholders are not subject to long-term capital gains as frequently as mutual funds are.
On the other hand, mutual fund investments must constantly be rebalanced. When the manager of a mutual fund rebalances the portfolio he or she must sell securities in order to reallocate the assets held. These transactions create a sale within the mutual fund portfolio. This triggers a capital gains tax because the shareholders of the funds will now have capital gains distributions.
Choosing a tax efficient investment allows you to retain more of your investment earnings and can help prevent you from creeping into a higher tax bracket. The lower the tax burden, the better. Make sure to always assess what the tax implications may be for an investment.