Returns matter for investors, but what really matter are after-tax returns.
Fortunately, the way exchange-traded funds (ETFs) are designed can help minimize the taxes paid by investors holding the ETF.
Here’s how it works: ETFs can engage in “inkind” transactions for their underlying securities, which avoid the realization of capital gains. This leads to lower capital gains taxes payable for those who hold an ETF in their portfolio. So, while investors will still realize capital gains for the increase in their purchase price versus their sale price, trading activity within the ETF likely won’t have any tax implications.
A Closer Look at the Tax Benefits
If the ETF’s price is higher than the fair value of its underlying holdings (its net asset value), the Authorized Participant will buy the underlying holdings of the ETF, pass these holdings to the issuer to create ETF shares (in the primary market), and sell the ETF shares trading at a premium on the exchange (i.e., the secondary market), profiting on the difference.
Contrastingly, if the ETF’s price is lower than the fair value of its underlying holdings, the Authorized Participant would buy the cheap ETF shares on the secondary market and redeem the shares in the primary market, profiting on the sale of the underlying holdings. This would eventually bring the ETF’s price up, eliminating much, or all, of its discount to net asset value. It is important to note that the Authorized Participant and ETF issuer aren’t selling shares back and forth—they’re passing them in and out of the fund “inkind” through the creation and redemption processes.
The difference may seem trivial, but this ability to create and redeem ETF shares “inkind” is what makes ETFs much more efficient from a tax perspective than mutual funds. When a stock (or bond) is purchased, that purchase price is captured for tax purposes as “cost basis.” Any increase or decrease in value is measured against that basis in terms of taxable gains or losses.
For mutual funds, each transaction involving a realized gain or loss is known as a taxable event. Taxable events thus accumulate throughout the year. At year end, the fund’s investors may receive a taxable distribution or “capital gains distribution,” representing the gains generated by the fund’s transactions passed along to the investor.
ETFs, on the other hand, through the creation and redemption process, allow the Issuer and the Authorized Participant to minimize taxable events by exchanging ETF shares and underlying securities “inkind” when possible, making capital gains distributions less likely. In this way, an ETF investor’s capital gains are not influenced by other investors entering and exiting the fund.
Always consult a tax professional for specific advice or recommendations.
Important Information
Published 7 April 2025
For mutual funds, each transaction involving a realized gain or loss is known as a taxable event. Taxable events thus accumulate throughout the year. At year-end, the fund’s investors may receive a taxable distribution or “capital gains distribution,” representing the gains generated by the fund’s transactions passed along to the investor.
ETFs, on the other hand, through the creation and redemption process, allow the Issuer and the Authorized Participant to minimize taxable events by exchanging ETF shares and underlying securities “in-kind” when possible, making capital gains distributions less likely. In this way, an ETF investor’s capital gains are not influenced by other investors entering and exiting the fund.
Always consult a tax professional for specific advice or recommendations.
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