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Investors can generally reduce their tax losses in a wallet using exchange traded funds on mutual funds, experts said.
“ETFs have tax magic unmatched by mutual funds,” said Bryan Armour, Morningstar’s director of passive strategies research for North America and editor of its ETFInvestor newsletter. wrote earlier this year.
But some investments benefit more than others from this so-called magic.
Tax savings are irrelevant in retirement accounts
The tax savings of ETFs are generally greater for investors in taxable brokerage accounts.
They’re a moot point for retirement investors, like those saving in a 401(k) plan or individual retirement account, experts said. Retirement accounts already enjoy a tax advantage, with contributions growing tax-free, meaning ETFs and mutual funds are on a level playing field when it comes to taxes, experts said .
The tax benefit “really helps the non-IRA account more than anything,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Fla., and founding member of Moisand Fitzgerald Tamayo.
“You’ll get tax efficiency that a standard mutual fund won’t be able to achieve, hands down,” he said.
The “primary use case” of ETFs
Mutual funds are generally less tax efficient than ETFs due to capital gains taxes generated within the fund.
Taxpayers who sell investments to realize a capital gain (i.e., profit) are likely familiar with the concept of paying tax on that income.
The same concept applies within a mutual fund: Mutual fund managers generate capital gains when they sell securities within the fund. The managers distribute these capital gains to investors each year; they distribute them equally among all shareholders, who pay taxes at their respective income tax rates.
However, ETF managers are generally able to avoid capital gains tax due to their unique structure.
The result is that asset classes that generate large capital gains relative to their total returns are “a primary use case for ETFs,” Armor told CNBC. (This discussion only applies to buying and selling within the fund. An investor who sells their ETF for a profit may still have to pay capital gains tax.)
Why US stocks “almost always” benefit from ETFs
U.S. stock mutual funds tend to generate the most capital gains compared to other asset classes, experts say.
Over five years, from 2019 to 2023, about 70% of U.S. equity mutual funds generated capital gains, said Armour, which cited Morningstar data. This was true for less than 10% of U.S. stock ETFs, he said.
Capital gains aren’t bad; these are investment profits. But ETF managers often avoid tax on those profits, unlike mutual funds, because of differences in how they can trade.
“It’s almost always an advantage to have your stock portfolio in an ETF rather than a mutual fund” in a non-retirement account, Armor said.
U.S. “growth” stocks — a subclass of stocks — saw more than 95% of their total returns come from capital gains in the five years through September 2024, according to Morningstar. That makes it “the biggest beneficiary of ETF tax efficiency,” Armor said.
Large- and small-cap “core” stocks also “benefit significantly,” with about 85% to 90% of their returns coming from capital gains, Armor 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 advantageous” U.S. stocks in an ETF, Armor said.
“They still benefit substantially,” he said.
Dividends from ETFs and Mutual Funds are taxed in the same way. ETF dividends are taxed based on how long the investor owns 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 frequently buy and sell positions to try to beat the market, he explained.
However, there are cases in which passively managed funds can also trade often, such as with so-called strategic beta funds, Armor said.
Bonds have less upside
ETFs are generally unable to “wipe out” tax liabilities related to currency hedges, futures or options, Armor said.
Additionally, tax laws in various countries may reduce the tax benefit of international stock ETFs, such as those investing in Brazil, India, South Korea or Taiwan, for example, he said.
Bond ETFs also have a smaller advantage over mutual funds, Armor said. Indeed, a large portion of bond fund returns generally comes from income (i.e. bond payments), not capital gains, he said.
Fitzgerald says he prefers to hold bonds in mutual funds rather than ETFs.
However, his reasoning has nothing to do with taxes.
During periods of high stock market volatility — when an unexpected event triggers lots of fear selling and a stock market decline, for example — Fitzgerald often sells bonds to buy stocks at a discount for clients.
However, during such periods, he has noticed that the price of a bond ETF tends to become more disconnected (compared to a mutual fund) from the net asset value of its underlying securities.
The bond ETF often sells at a lower price compared to a similar bond mutual fund, he said. Selling the bond position at a lower price somewhat dilutes the benefits of the overall strategy, he said.