Since the introduction of the first ETF in the U.S. in 1993, ETF trading volume has grown to range between 25% to 30% of U.S. equity trading volume.1
This popularity is in part due to the fact that many ETFs investing in equities and fixed income securities have many of the same advantages of similarly invested mutual funds, but are generally more tax efficient due to how they’re structured.
Both ETFs and mutual funds offer built-in diversification, which can help individual investors achieve diversification, without spending a lot of capital or having to manage dozens of individual stocks and bonds.
While ETFs and mutual funds are similar on the surface, they have a big difference that often results in ETFs being more generally tax efficient: their structure.
With mutual funds, investors send cash to buy into the fund, then fund manager uses the cash in the fund to buy the fund’s underlying securities, and they issue shares of the fund to investors. When a mutual fund manager sells securities held in the fund to rebalance the portfolio, or to raise cash to cover fund redemptions, this action can generate capital gains for the fund’s shareholders — and thus capital gains taxes.
By contrast, with ETFs there is an issuer who buys the shares of the underlying securities held by the fund, and puts them in a trust. Then they issue shares of the trust that investors buy as the ETF. Instead of working with cash, the ETF manager uses “creation units” to handle inflows into the fund, as well as shareholder redemptions. This process results in fewer internal capital gains to be passed on to shareholders, making ETFs generally more tax-efficient than their mutual fund counterparts.2
Often in both mutual funds and ETFs, when the investor sells their shares, they will likely generate capital gains (if the shares appreciated) or losses (if the shares depreciated) within their individual portfolio. Whether those capital gains are taxed at the short-term rate or the long-term rate depends on how long the investor held the shares.
In addition to the capital gains from selling the fund shares, mutual fund investors will likely be subject to capital gains taxes when the fund manager sells underlying investments that aren’t balanced by capital losses. Whether those capital gains taxes are short- or long-term depends on how long the fund has held those underlying investments.
In other words, in addition to generally having fewer taxable events, the capital gains from ETFs are almost entirely under the control of the investor.
While capital gains are the primary concern when investing in equity and fixed-income ETFs, there are additional taxes to consider that are less common.
The taxation of any dividends thrown off by the ETF is governed by how long the investor has owned the ETF. If the ETF has been owned for more than 60 days prior to the issuance of the dividend, then it is treated as a qualified dividend. This means that the dividend is taxed at the investor’s rate for long-term capital gains, which is often favorable when compared to their tax rate for ordinary income.
Dividends received from an ETF held for fewer than 60 days will be taxed at your ordinary income tax rate. For many investors, this rate may be higher than the long-term capital gains rate.2
This differs from mutual funds in that the investor’s holding period does not impact the taxation of dividends held inside of the fund.
Commodity ETFs. Many commodity ETFs are structured as limited partnerships and report income to shareholders via a K-1 versus a 1099 form, which can make tax filing a bit more complex for some shareholders. For ETFs that invest via commodity futures, capital gains are treated as 60% long-term gains and 40% short-term gains, regardless of how long you have owned the ETF.
Currency ETFs. Currency ETFs are generally structured as a grantor trust, meaning that any profit from the trust is taxed as a short-term capital gain, regardless of your holding period for the ETF.
Crypto ETFs. Crypto ETFs that hold the actual crypto currency are grantor trusts, and gains will be taxed as ordinary income. Those who invest in crypto futures contracts will have gains taxed as 60/40 long-term/short-term gains regardless of the investor’s holding period.
Precious metals ETFs. ETFs that invest in precious metals will see short-term gains taxed as ordinary income and long-term gains taxed at the collectibles rate, which can be as high as 31.8% including the NIIT.
This chart summarizes the tax treatment of many types of ETFs for easier reference.1,2,3,4
| Type of transaction | How is the transaction taxed? | Details |
|---|---|---|
| Long-term gains on sale of most ETFs | If held for at least one year, then the gains are treated as long-term capital gains. | Taxed at long-term capital gains rate; actual rate depends on the investor’s income level. This could be up to 20% plus the 3.8% net investment income tax (NIIT) rate for high income investors. |
| Short-term gains on sale of most ETFs | If held for less than one year, then the gains are treated as short-term capital gains. | Taxed as ordinary income based on the investor’s tax rate. |
| Dividends and interest on most ETFs owned for 60 days or more | Qualified | Taxed at the investor’s long-term capital gains rate, including NIIT for high income investors. |
| Commodity Futures ETFs | Specialized rate | Regardless of holding period, gains and losses are treated as 60% long-term and 40% short-term. |
| Currency ETFs | Generally structured as a grantor trust. Can also be structured as open-end funds or partnerships. | If structured as a grantor trust, they’re taxed as a short-term capital gain (ordinary income) regardless of the investor’s holding period. |
| Crypto ETFs | 1. Spot crypto ETFs structured as grantor trusts. 2. Crypto ETFs that invest in futures contracts. | 1.If structured as a grantor trust, then all gains are taxed as short-term. 2. Taxed as 60/40 in the same fashion as commodity futures ETFs. |
| Precious metals ETFs | Generally classified as a collectible. | Short-term gains are taxed as ordinary income. Long-term capital gains may be taxed as high as 28%. |
Understanding the tax implications of ETFs in general, or of a particular ETF you may be considering, is an important aspect of choosing to invest in ETFs over another investment vehicle.
Understanding when and how taxable events occur in a particular ETF might also influence the best account to hold that ETF. An ETF that throws off a lot of taxable income may be better suited for a tax-advantaged account, like an IRA versus a taxable account.
As always, though, the most important decision about investing in an ETF is whether or not the ETF fits with the overall investment strategy.