How Are ETFs Taxed?

The ease of buying and selling exchange-traded funds (ETFs), along with their low transaction costs, have made them popular with investors. They account for over 30% of the daily trading volume on U.S. stock exchanges. They are also more tax-efficient, which is integral to their appeal, especially when competing with mutual funds for your investment dollars. But how much of an advantage do they offer?

Investors need to understand this to strategize better using these funds in their portfolios. We'll begin by exploring the tax rules that apply to ETFs and the exceptions you should know. We also give you numbers from the most recent research on how much the tax benefit of ETFs is. Then, we will show you some money-saving tax strategies that can help you earn a higher return.

Taxes on ETFs

ETFs are often said to have better tax treatment than mutual funds because of their structure. They create and redeem shares using in-kind transactions, which aren't considered sales and, therefore, don't trigger taxable events. This arises from a section of the U.S. Internal Revenue Code of 1986, Section 852(b)(6), which exempts the distribution of capital gains when the shares that have appreciated in value are given to "in kind" redeeming investors (namely the market makers for the ETFs).

That's the overall structure behind ETFs. However, selling your shares in an ETF is a taxable event. Whether you have a long-term or short-term capital gain or loss depends on how long you've held the shares. In the U.S., you need to hold an ETF for more than a year to benefit from any sale being treated as long-term capital gains. If you hold it for a year or less, it's considered a short-term gain, which typically results in a higher tax rate.

The Data on the Tax Advantages of ETFs

Financial advisors and websites often tout how ETFs are more tax-efficient than mutual funds. Studies have also shown that this tax efficiency has been a major part of their appeal for investors choosing between the two. However, while the conventional wisdom on this is everywhere, data behind the claim is not. However, without specifics, it's hard to weigh this advantage against other investment options, including mutual funds.

Recent research offers a clearer picture of any advantages, but you might want to temper expectations should you anticipate eye-popping numbers. For decades, the tax benefits of ETFs have been among the "just so" stories on Wall Street. It goes like this: When mutual fund managers buy and sell securities within the fund, capital gains from these transactions are passed on to investors as distributions, which are typically taxable events, even if you don't sell your shares. Meanwhile, ETFs use a creation and redemption process that involves in-kind transactions, allowing them to avoid triggering capital gains taxes until investors sell their ETF shares. This makes ETFs more tax-efficient.

While the creation and redemption structure of ETFs does offer a tax advantage, there's reason to think any such differences between ETFs and mutual funds have narrowed. For example, mutual funds have reduced turnover rates, often in a bid to compete with ETFs by cutting fees and the number of taxable events for shareholders. Although not always the case, lower turnover rates should result in more tax efficiency (though what assets are turned over and when is crucial), especially for equities funds. In recent years, comparable passively managed index mutual funds and ETFs have had similar turnover rates.

So, is there a tax advantage for ETFs over mutual funds? A Villanova and University of Pennsylvania study updated in early 2024 puts their overall average annual after-tax advantage at 0.92%. While to many, this might not seem like much, those who shop around for minute differences in expense ratios and know the power of compounding can see that, while not earth-shattering, it's significant. Indeed, the authors conclude it's enough to be "a significant driver of the capital migration by high-net-worth investors from mutual funds into ETFs." Drilling down into their numbers, though, we see less of a difference between, for example, index mutual funds and similar ETFs. Using a method giving them bottom-line results supposing all investors are from the highest tax brackets (thus amplifying potential differences between the two fund types) and data from the 1990s to 2017 (which cuts off some of the recent movement of mutual funds toward more ETF-like turnover on average), they found the annual average tax burden of a passively managed ETF was 0.37% against 0.84% for a mutual fund.

Other studies show more of a convergence. For example, Derek Horstmeyer, a professor of finance at George Mason University, pulled data on ETFs and mutual funds with similar holdings, choosing pairs with the same objectives within the same mutual fund families. While not a large sample—he and his colleagues used 10 matched pairs in each of six asset classes—it's not too broad either, giving you macro figures on all ETFs and mutual funds in a way that isn't very actionable. The data showed that ETFs provide an extra 0.20% post-tax performance compared with their mutual fund counterparts. The differences varied across asset classes, ranging from 0.33% for international equity funds to 0.03% for fixed-income funds.

To make this concrete, data for U.S. large-cap ETFs and mutual funds showed annualized 10-year returns of 10.11% and 9.95%, respectively. This means that over a decade, investors who put $100,000 in a mutual fund would have about $3,700 less than if they had invested in an ETF. For other sectors, Horstmeyer found the following differences: small-cap equity, 0.20%, growth equity funds, 0.22%, and value funds, 0.20%.

These numbers make clear that tax efficiency shouldn't be the sole factor driving your investment decision. Other aspects, like investment strategy, fees, and portfolio goals, might make more of a difference in your after-tax returns. Therefore, it's essential to dig into each fund's specific details to make a choice that aligns with your financial goals. Seeking the advice of a tax professional is also always a prudent part of this.

Tax Strategies vs. Tax Avoidance

While perhaps mutual funds have lowered some tax-efficiency differences, ETF investors have not stood still, looking for means to increase the potential tax advantages of these funds. Below, we'll discuss other strategies, but one recent study puts numbers to what the New York Times was reporting as long ago as 1998: traders often get around the federal law against wash sales by using ETFs. A wash sale is when you sell or trade a security at a loss and then, within 30 days of the sale, buy, trade, or obtain a contract or option to purchase a substantially "substantially identical" one.

When investors attempt to claim a tax deduction for a loss on a security while quickly repurchasing the same or very similar security, it's seen as an attempt to artificially book a loss without actually changing their investment positions. In short, those doing this are trying to capture the loss for tax purposes without taking any real risk in the market. The Internal Revenue Service (IRS) considers this an abuse of tax laws designed to prevent taxpayers from claiming unjustified deductions. Wash sales have long been illegal for securities like stocks.

One would think it would thus be illegal for ETFs, but a 2023 ProPublica report found tax experts divided and no record of IRS enforcement on the matter. They also detail trades that, while nearly a decade old, look like classic examples of what the wash sales laws were meant to ban. Working with IRS tax records, they reported that in 2015, Brian Acton, the co-founder of WhatsApp, sold $17 million in shares of Vanguard’s emerging markets ETF, booking a loss of $2.9 million. The same day, Acton put $17 million into Blackrock's emerging markets ETF, essentially purchasing very similar holdings amassed in the same mix of Chinese and other companies with a similar record of returns.

Having already booked those trades, later that year, Acton did the same in reverse after the Blackrock ETF began to decline. He sold the Blackrock and went back to Vanguard, booking another $600,000 in tax losses. Thus, in a year in which his emerging market ETF holdings were largely unchanged, according to ProPublica, Acton booked $3.5 million in losses just counting these two trades.

He was far from alone. A recent study by Wentlao Li from Oxford University shows the extent to which investors have been taking advantage. Li notes what we've described before, namely how investors are using ETFs to engage in tax-loss harvesting. (He labels Investopedia's article as "guidance" to doing these trades, but we merely describe the practice.) "Tax-loss harvesting with ETFs resides in a regulatory grey area of U.S. tax law," he writes while explaining well how the IRS has left open a situation where if you sell an ETF at a loss and repurchase the same one within a month, you engage in a wash sale. However, if it's a different ETF, no matter how similar the holdings and objectives, as in the Acton example, you can treat the wash-sale rule as inapplicable. The study notes that this is even the case for ETFs whose returns have a 99.67% correlation.

Li and ProPublica both cite advertisements from asset managers touting the benefits of a strategy that would be illegal for other securities, but Li adds to previous reporting by going beyond specific cases and giving us a picture of how it's affecting the market. The study reports that for ETFs whose returns are highly correlated, about 9.1% trading volume of their AUM is related to tax-loss harvesting, or about 20.7% of these ETFs' total trading volume. It also shows that this is most pronounced for highly liquid funds with high AUMs, so this is a practice far from the margins of the trading world.

Li ends the study by calling on regulators to clarify IRS rules to ensure that traders aren't engaging in wash sales of "substantially identical" ETFs, noting that about $30 billion in 2024 USD is lost to taxpayers annually through these trades. This, he says, is a subsidy to ETF traders by other investors. Some analysts have suggested changes to federal law, like adjusting the notion of "substantially identical" to "substantially similar," though any changes could still be difficult to enforce while inhibiting some of what would otherwise be legal trading among actually different ETFs. In the meantime, traders will continue to seize the advantage. Perhaps demonstrating the law of unintended consequences and it's not a problem that's going away, Li's study was reported in Financial Planning under the headline "Study Finds 'New Source of Tax Efficiency for ETFs.'"

Dividends and Interest Payment Taxes

With the broader ETF tax discussion out of the way, we can get down to the details you need when trading. Dividends and interest payments from ETFs are taxed like income from the underlying stocks or bonds they hold. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. If you profit by selling shares in an ETF, that is taxed, like when you sell stocks or bonds.

If you hold an ETF for more than a year, you'll pay up to 20% in long-term capital gains tax. Individuals with substantial investment income may also pay an additional 3.8% net investment income tax (NIIT). ETFs held for less than a year are taxed at ordinary income rates, which go up 37%, plus an additional 3.8% NIIT for some.

As with stocks, you are subject to the wash-sale rules, as we noted above. If your loss was disallowed because of the wash-sale rules, you should add the disallowed loss to the cost of the new ETF shares. This increases your basis in the new ETF, which postpones the deduction until you sell it. Your holding period for the new ETF begins on the same day as the holding period for the ETF shares that were sold.

Most ETFs hold dividend-paying stocks. The dividends they pay you can be either ordinary (taxable) or qualified (taxed at lower capital gains rates). Your ETF provider will specify which type you received. For example, if your ETF holds Apple Inc. (AAPL) stock and Apple pays a qualified dividend, that money flows through the ETF to you as a qualified dividend. But if your ETF holds bonds, the interest payments are ordinary dividends. These dividends are taxable when paid by the ETF.

Exceptions: Currency, Futures, and Metals

There are exceptions to the general tax rules for ETFs. An excellent way to think about these exceptions is to know the tax rules for specific sectors since the ETF likely follows those tax rules. Currencies, futures, crypto, and metals are the sectors that receive special tax treatment.

Currency ETFs

Most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years. Since currency ETFs trade in currency pairs, the taxing authorities may assume that these trades take place over short periods.

Futures ETFs

These trade commodities, stocks, Treasury bonds, and currencies. For example, Invesco DB Agriculture ETF (DBA) invests in futures contracts of specific agricultural commodities—corn, wheat, soybeans, and sugar—not the crops themselves.

Gains and losses on the ETF's futures are treated for tax purposes as 60% long-term and 40% short-term, no matter how long the ETF held the contracts. In addition, ETFs that trade futures follow mark-to-market rules at year-end. This means that unrealized gains at the end of the year are taxed as if they were sold.

Metals ETFs

If you invest in gold, silver, or platinum bullion, the tax authorities consider it a "collectible" for tax purposes. The same applies to ETFs that hold them. As a collectible, if your gain is short-term, then it is taxed as ordinary income. If your gain is earned for more than a year, you are taxed at a capital-gains rate of up to 28%. This means you can't take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver, or platinum. The ETF provider will have information for you on what is considered short-term vs. long-term gains or losses.

Crypto ETFs

Spot crypto ETFs that hold actual cryptocurrency and are structured as grantor trusts have the same tax rules that govern spot commodity ETFs, according to Grayscale, which operates one of the leading spot bitcoin ETFs. If the ETF makes distributions to shareholders (e.g., from staking rewards or airdrops), these distributions may be treated as ordinary income and taxed at the investor's ordinary income tax rate.

Crypto ETFs invested in futures contracts are instead subject to the 60/40 rule, which treats 60% of their gains or losses as long-term capital gains or losses and the remaining 40% as short-term capital gains or losses, whatever the actual holding period.

It's important to note that the specific tax treatment may depend on the investor's jurisdiction, the structure of the ETF, and other factors. Additionally, crypto ETFs are relatively new, and the tax laws and regulations surrounding them may change.

Tax Strategies Using ETFs

ETFs lend themselves to helpful tax-planning strategies, especially if you have a portfolio that blends stocks and ETFs. A common one is closing out positions with losses before their one-year anniversary. You then keep positions that have gained for more than a year. This way, your gains receive long-term capital gains treatment, lowering your tax liability. Of course, this applies to stocks as well as ETFs.

In other situations, you might own an ETF in a sector you believe will perform well, but the market has pulled all sectors down, giving you a slight loss. You are reluctant to sell because you think the industry will rebound and could miss the gain because of wash-sale rules. In this case, you can sell the current ETF and buy another that uses a similar but different index. This way, you still have exposure to the favorable sector, but you can take the loss on the original ETF for tax purposes.

ETFs are a valuable tool for year-end tax planning. Suppose you own a collection of stocks in the materials and health care sectors that are at a loss. However, you believe that these sectors are poised to beat the market during the following year. One strategy is to sell the stocks for a loss and then purchase sector ETFs that still expose you to the sector.

The Bottom Line

Investors with ETFs in their portfolios can add to their returns if they use their tax treatment to their advantage. Due to their unique characteristics, many ETFs offer investors prospects to defer taxes until they are sold. In addition, as you approach the first anniversary of your purchase of the fund, you should consider selling those with losses before their first anniversary to take advantage of the short-term capital loss. Similarly, you should consider holding those ETFs with gains past their first anniversary to take advantage of the lower long-term capital gains tax rates.

ETFs that invest in currencies, metals, and futures have specific rules. They follow the tax rules for the underlying assets, which are usually taxed as short-term gains.