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“Are ETFs more tax efficient than mutual funds?”

As a reminder, this week is all about taxes – and specifically, what you can do to invest more tax efficiently.

Today we look at a question about another type of investment and its tax advantages, ETFs.

The question is:

“Are ETFs more tax efficient than mutual funds?”


Transcript - Why ETFs are More Tax Efficient Than Mutual Funds

Although no blanket statement can be made that all ETFs are more tax efficient than mutual funds. In general it proves to be true.

ETFs added tax efficiency is due to the differences in how ETFs are structured compared to mutual funds.

When you sell a mutual fund, the mutual fund company must sell assets in the fund to raise cash. This may mean selling investments that have gone up in value and therefore have large capital gains.

Mutual funds are required to pass these taxable gains onto investors at the end of the year, and that means you the investor get a taxable distribution at the end of the year.

ETFs on the other hand, primarily change hands on the secondary market, directly from one investor to another. This means most transactions do not require the ETF manager to sell assets of the fund and generate taxable gains for investors.

This difference is most pronounced in actively managed mutual funds. As an example, look at a mutual fund that we discovered after a client moved their investments to us from another bank. The fund is managed by UBS, it is the Pace Large Cap Growth Fund, ticker symbol PCLCX.

At the end of 2018, the fund had to make a taxable distribution to investors equal to 17% of the funds assets. This means if you were an investor with $100,000 invested in the fund, you got an extra tax bill of more than $2,500 assuming It was taxed at 15%.

These types of distributions and their subsequent tax bill could have largely been avoided by investing through a large cap growth ETF.

Matt Hylland