How mutual funds & ETFs are taxed | Vanguard (2024)

FAQs

How mutual funds & ETFs are taxed | Vanguard? ›

Funds buy & sell too

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.

Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.

For investors who like the convenience and built-in diversification of a mutual fund, equity exchange-traded funds can make fine, tax-efficient options for taxable accounts. Most ETFs track indexes, so their turnover is often very low, meaning that capital gains distributions also tend to be few and far between.

ETFs structured as open-end funds, also known as '40 Act funds, are taxed up to the 23.8% long-term rate or the 40.8% short-term rate when sold.

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.

Capital gains distributions are paid by mutual funds from their net realized long-term capital gains and are taxed as long-term capital gains regardless of how long you have owned the shares in the mutual fund. Mutual funds may keep some of their long-term capital gains and pay taxes on those undistributed amounts.

Since mutual fund trusts are taxed at a rate equivalent to the highest personal tax rate, any income retained by a mutual fund is typically subject to more tax than if it were taxed in the hands of individual investors.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.

The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often.

For the most part, ETFs are less costly than mutual funds. There are exceptions—and investors should always examine the relative costs of ETFs and mutual funds. However—all else being equal—the structural differences between the 2 products do give ETFs a cost advantage over mutual funds.

When you sell shares in ETFs, you'll have a capital gain or loss, depending on your basis in the shares. This is no different than the tax treatment that applies to the sale of shares in individual stocks or in mutual funds. See chart below for 2024 rates.