Understanding capital gains: How ETFs can help minimize taxes

Effective tax management can help unlock your portfolio's full potential. One strategy may be to limit certain types of capital gains distributions that add to your tax bill. Exchange-traded funds (ETFs) are a tax-efficient way to invest. ETFs are structured to reduce distributions, helping you keep more of what you earn.

What are capital gains, and how are they taxed?

A capital gain is an investor’s profit on the sale of investable assets, such as stocks, bonds, and real estate. That sounds positive — and it is. But investors have to pay taxes on realized capital gains when they sell. Investors should also understand that they may be taxed on capital gains from funds they own — even if they don’t sell their fund shares. With certain types of funds, if a fund manager sells a holding at a profit (without having any losses to offset the gain), then the gains are distributed to the fund shareholders. ETFs, however, have structural features which potentially help them avoid these types of distributions.

Why are ETFs tax efficient with capital gains?

A primary reason so many investors have gravitated to ETFs in recent years is their tax efficiency. The tax benefits of ETFs are rooted in their in-kind creation and redemption feature. ETF creation and redemption may avoid the cash transactions that trigger unwanted taxable events for investors in mutual funds.

In 2023, only 40, or 2%, of Invesco’s ETFs, distributed capital gains for one of the lowest percentages in the industry.¹ And many, such as Invesco NASDAQ 100 ETF (QQQM), Invesco S&P 500^® Equal Weight ETF (RSP), and Invesco S&P 500^® Quality ETF (SPHQ), have never paid capital gains distributions in their lifetime.

How common are capital gains distributions for US equity mutual funds?

In 2023, 60% of US equity mutual funds paid capital gains distributions to their shareholders. Over the past 10 years, the average annual distribution from US equity style box mutual funds ranged from 5% to 8% of the fund’s net asset value.² Paying taxes on those distributions can erode portfolio returns over time. Capital gains are generally distributed to fund holders once a year, usually in December.

In 2023, of the 1,787 ETFs offered by the 15 largest US issuers, only five of those funds, distributed capital gains in excess of 1%.¹

How are long-term capital gains taxed?

US tax policy is often complex and fluid. But long-term capital gains tax rules for positions held over one year are relatively straightforward. For 2024, investors earning between $47,025 and $518,900 annually and married couples filing jointly earning between $94,051 and $583,750 are subject to a 15% long-term capital gains tax rates, according to the IRS.³ Taxable income above $518,900 for single filers and $583,750 for jointly filing married couples is subject to a 20% long-term capital gains tax rate.³