Shout out to The Real Estate Captain (TREC) for inspiring today’s post! After concluding my prior post on Choosing the Best Index Fund, TREC asked, “Out of curiosity, what makes ETFs more tax-efficient in after-tax brokerage accounts? Have you written anything on it before? Would be interested in understanding more!“
Thus, inception occurred, and today’s post was dreamt.
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Refresher on Mutual Funds & ETFs
As you will recall in my post, What is a Fund, mutual funds and ETFs help you accomplish the same goal: Diversified hands-off investing!
With mutual funds, they do this by acting as a one-stop shop. You buy and sell directly from them, and in return, they allow you to transact in any increment you want. All transactions go into a queue and occur once per business day at 4 pm EST, allowing all inflows and outflows to be managed by the fund with ease.
Remember, mutual funds hold your money and invest it within securities; this means if there is too much money leaving, they have to liquidate! Thus, using a queue allows fund managers to minimize the number of purchases or sales they must complete on any given day.
On the other hand, ETFs create a bundle of assets and sell them to the public once. After that, the fund does not interact with you directly; instead, they manage the investments and do not deal with purchases or redemptions, generally. As a result, mutual funds have more work involved day to day than ETFs! However, if there is sufficient demand, ETFs may create additional asset bundles so that more people can own their fund.
Despite their differences, mutual funds and ETFs can follow the same index or strategy. If you hold either mutual funds or ETFs in a tax-preferred account, such as an IRA or 401(k), few differences are material other than your ability to day trade ETFs and transact any dollar amount with mutual funds.
However, when held in taxable accounts, the differences can affect your returns and taxes!
Taxes on gains
Under IRS Regulation M, mutual funds and ETFs do not have to pay taxes on gains. However, these gains must be paid out to their fundholders so that they can be taxed. By doing this, double taxation is avoided, and the actual owners of the investments, you and me, are taxed.
Structure matters
So, as we learned two sections prior, ETFs are essentially closed businesses: They buy and sell securities to match their index or strategy without day-to-day investor interactions. Just like stocks and bonds, ETF ownership can be transferred. If someone wants to buy an ETF, they buy it from someone who already owns it. Mutual funds, however, do not let you transfer your ownership.
Instead, when you want to buy and sell a mutual fund, you transact directly with it. Thus, when trading activity increases, it can increase taxable events for mutual fund holders.
For example, investors historically are more likely to request their money back during a market crash (you should never do this, FYI!). When this occurs, the fund must sell investments that it holds. Inevitably, some of these investments will have appreciated, and when the sale occurs, Uncle Sam wants their cut.
Thus, under Regulation M, mutual funds have to distribute these gains so that you and I can pay taxes. Now, because ETFs are less likely, in theory, to have to sell their underlying investments, they tend to have fewer taxable events for fundholders.
Significantly, this only matters when a fundholder places a mutual fund or ETF in a taxable account, such as an after-tax brokerage account. If you hold mutual funds or ETFs in a tax-advantaged account, like an IRA or 401(k), this doesn’t matter.
In summary
Now, if you already have mutual funds in your taxable accounts, don’t panic. By now, you likely have appreciated substantial gains on these funds over the years. If you continue to hold them, they will remain untaxed. If you sell these mutual funds so that you incur fewer capital gains in the present, you will likely have a sizable tax bill. Instead, use this knowledge going forward to invest strategically!
However, if you are starting your journey, use this post as another tool in your knowledge box. Regardless of where you are on the journey to financial freedom, thanks for reading today’s post and let me know in the comments below how you plan to implement this! As always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time
What a treat to log in on a Wednesday night and see my question answered! Thanks for the thorough response, great article. And thanks for the nickname TREC – that one could stick!