Investors can generally reduce their tax losses in a portfolio by using exchange-traded funds over mutual funds, experts said.
“ETFs come with tax magic that’s unrivaled by mutual funds,” Bryan Armour, Morningstar’s director of passive strategies research for North America and editor of its ETFInvestor newsletter, wrote earlier this year.
But certain investments benefit more from that so-called “magic” than others.
Tax savings are moot in retirement accounts
ETFs’ tax savings are typically greatest for investors in taxable brokerage accounts.
They’re a moot point for retirement investors, like those who save in a 401(k) plan or individual retirement account, experts said. Retirement accounts are already tax-preferred, with contributions growing tax-free — meaning ETFs and mutual funds are on a level playing field relative to taxes, experts said.
The tax advantage “really helps the non-IRA account more than anything,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida, and a founding member of Moisand Fitzgerald Tamayo.
“You’ll have tax efficiency that a standard mutual fund is not going to be able to achieve, hands down,” he said.
The ‘primary use case’ for ETFs
Mutual funds are generally less tax-efficient than ETFs because of capital gains taxes generated inside the fund.
Taxpayers who sell investments for a capital gain (i.e., a profit) are likely familiar with the concept of paying tax on those earnings.
The same concept applies within a mutual fund: Mutual fund managers generate capital gains when they sell holdings within the fund. Managers distribute those capital gains to investors each year; they divide them equally among all shareholders, who pay taxes at their respective income tax rate.
However, ETF managers are generally able to avoid capital gains taxes due to their unique structure.
The upshot is that asset classes that generate large capital gains relative to their total return are “a primary use case for ETFs,” Armour told CNBC. (This discussion only applies to buying and selling within the fund. An investor who sells their ETF for a profit may still owe capital gains tax.)
Why U.S. stocks ‘almost always’ benefit from ETFs
U.S. stock mutual funds have tended to generate the most capital gains relative to other asset classes, experts said.
Over five years, from 2019 to 2023, about 70% of U.S. stock mutual funds kicked off capital gains, said Armour, who cited Morningstar data. That was true of less than 10% of U.S. stock ETFs, he said.
“It’s almost always an advantage to have your stock portfolio in an ETF over a mutual fund” in a non-retirement account, Armour said.
U.S. “growth” stocks — a stock sub-category — saw more than 95% of their total return come from capital gains in the five years through September 2024, according to Morningstar. That makes them “the greatest beneficiary of ETFs’ tax efficiency,” Armour said.
Large-cap and small-cap “core” stocks also “benefit considerably,” with about 85% to 90% of their returns coming from capital gains, Armour said.
About 25% to 30% of value stocks’ returns come from dividends — which are taxed differently than capital gains within an ETF — making them the “least beneficial” U.S. stocks in an ETF, Armour said.
“They still benefit substantially, though,” he said.
ETF and mutual fund dividends are taxed similarly. ETF dividends are taxed according to how long the investor has owned the fund.
Actively managed stock funds are also generally better candidates for an ETF structure, Fitzgerald said.
Active managers tend to distribute more capital gains than those who passively track a stock index, because active managers buy and sell positions frequently to try to beat the market, he said.
However, there are instances in which passively managed funds can trade often, too, such as with so-called “strategic beta” funds, Armour said.
Bonds have a smaller advantage
ETFs are generally unable to “wash away” tax liabilities related to currency hedging, futures or options, Armour said.
Additionally, tax laws of various nations may reduce the tax benefit for international-stock ETFs, like those investing in Brazil, India, South Korea or Taiwan, for example, he said.
Bond ETFs also have a smaller advantage over mutual funds, Armour said. That’s because an ample amount of bond funds’ returns generally comes from income (i.e., bond payments), not capital gains, he said.
Fitzgerald says he favors holding bonds in mutual funds rather than ETFs.
However, his reasoning isn’t related to taxes.
During periods of high volatility in the stock market — when an unexpected event triggers a lot of fear selling and a stock-market dip, for example — Fitzgerald often sells bonds to buy stocks at a discount for clients.
However, during such periods, he’s noticed the price of a bond ETF tends to disconnect more (relative to a mutual fund) from the net asset value of its underlying holdings.
The bond ETF often sells at more of a discount relative to a similar bond mutual fund, he said. Selling the bond position for less money somewhat dilutes the benefit of the overall strategy, he said.