How ETFs can make capital gains more tax efficient

Finding the right investment mix will help you meet your financial goals. But reaching your portfolio's full potential may require an effective tax management strategy. Limiting certain types of capital gains distributions can help reduce your tax bill. Exchange-traded funds (ETFs) are a tax-efficient way to invest. By reducing distributions, ETFs help you keep more of what you earn.

What's a capital gain, and why do they matter to fund investors?

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 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 often more tax efficient with capital gains than mutual funds?

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 one of Invesco’s ETFs, or 0.46%, distributed capital gains for one of the lowest percentages in the industry.¹ And many, such as Invesco NASDAQ 100 ETF, Invesco S&P 500 Equal Weight ETF, and Invesco S&P 500 Pure Value ETF, 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 mutual funds ranged from 2.9% to 11.9% 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 1,736 ETFs offered by the 15 largest U.S. issuers, only 6 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. According to the IRS, investors earning less than $492,300 annually and married couples filing jointly earning less than $553,850 are subject to long-term capital gains tax rates of 15%.³ Taxable income above $492,300 for single filers and $553,850 for jointly filing married couples results in a long-term capital gain tax rate of 20%.³

Next steps

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