ETF tax benefits: Why ETFs can be efficient investments

Many investors may turn to exchange-traded funds (ETFs) for more transparency¹ or lower costs². But ETFs are also tax efficient³. They typically generate fewer capital gains than mutual funds due to how they’re structured and traded in the marketplace. Fewer capital gains to tax means investors potentially get to keep more of their returns.

How are ETFs created?

ETF creation and redemption typically avoid the cash transactions that may trigger capital gains distributions. Generally, an ETF issuer creates and redeems ETF shares through an “in-kind” process involving large institutional investors and market makers called authorized participants (APs). The APs have an agreement with the ETF manager that lets them create or redeem ETF shares in large blocks known as creation units. A creation unit typically consists of 10,000, 20,000, 25,000, 50,000, 80,000, 100,000, or 150,000 shares.

During the creation process, when demand for the ETF exceeds supply, the AP delivers a basket of securities held in the ETF to the issuer in exchange for a creation unit. In a redemption, however, the process is reversed. The AP receives a basket of securities while the ETF manager takes back a creation unit. ETF shares can be quickly created or redeemed elastically without cash transactions to help meet supply and demand in the marketplace.

Why do ETFs have fewer tax implications?

Since these transactions happen in shares (in-kind) and not in cash, there are typically no capital gains. What’s more, current tax law states that capital gains are not recognized at the time of the transaction and thereby not considered a taxable sale. The ETF creation and redemption structure may create meaningfully different after-tax returns between an ETF and an index-tracking mutual fund — even if both track the same index.

With ETFs, capital gains and taxes are generally recognized only when investors sell their own shares. On the other hand, mutual fund investors can see gains and taxes impacted by the selling activity of the fund’s other shareholders.

How do common ETF events affect taxes?

Portfolio rebalancing

Rebalancing a portfolio is typically handled in-kind with transactions and generally not taxable for the ETF and its shareholders. If the ETF must sell securities no longer in the index and buy additional securities, though, this may be a cash transaction and a taxable event for the ETF.

Corporate events

Stock splits, mergers, acquisitions, and other corporate events are also typically handled in-kind. But if the ETF must sell or buy securities for cash, there may be a taxable event for the ETF.

Shareholder redemption

When APs redeem their shares, this is usually handled with “in-kind” transactions rather than cash, which helps prevent distributions and taxes for shareholders.