How You Can Utilize the Durable Tax Efficiency of ETFs

Over the past two decades, the cost of fund ownership has declined visibly. Expense ratios have fallen, index funds have gained market share, and low-cost portfolio construction has exploded in popularity for individual investors. But one of the most important costs of investing is not considered until after the bill arrives: taxes.

Tax treatment is where exchange-traded funds have one of their most durable advantages over mutual funds. ETFs are not just cheaper, more transparent, or easier to trade. In taxable accounts, they often give investors better control over when capital gains are realized. That feature has helped ETFs become a preferred vehicle for US stock exposure and should continue to drive demand for more ETFs.

Investment vehicle flows confirm how powerful the shift out of mutual funds and into ETFs has become. According to Morningstar’s US fund-flows data, ETFs gathered nearly $1.5 trillion in inflows in 2025, showing how investor preferences are shifting. And as of June 2026, ETFs now represent roughly 39% of the combined ETF and mutual fund market. This is almost twice the market share ETFs held in 2020. Additionally, the growth is not limited to passive index funds. Asset managers have found success in launching actively managed ETFs, showing that both passive and active managers increasingly view the ETF as a preferred vehicle going forward.

The Mutual Fund Tax Problem

Mutual funds and ETFs are both pooled investment vehicles, capable of holding thousands of stocks, bonds, or other securities. Both pass through dividends, interest, and realized capital gains to shareholders. But the way investors enter and exit these vehicles can produce very different tax outcomes.

A traditional mutual fund only transacts with cash. It purchases stocks or bonds when investors put cash into the fund, and it sells stocks and bonds for cash when investors want to pull their money out.

Managers have choices when they choose what to sell, but those choices might shrink when a lot of investors want their money back. Such a situation may force a manager to sell portfolio holdings with appreciated prices and realize capital gains. By law, mutual funds must distribute those realized capital gains to shareholders.

This creates a less-than-ideal outcome for the investors who remain and hold the mutual fund inside of a taxable brokerage account. They’ll receive capital gains distributions even though they did not sell any of their own shares. In effect, one shareholder’s redemption can create taxable consequences for the shareholders who remain.

Investors typically think about capital gains only when they are the ones transacting. By selling a mutual fund or ETF that has appreciated, they pay either long- or short-term capital gains taxes depending on how long they held their investment. But being forced into a tax liability triggered by activity inside the fund can have a negative impact on a person’s tax-optimized financial plan.

To be clear, mutual funds are not automatically tax-inefficient. Broad, low-turnover, index-tracking mutual funds can be highly tax-efficient. And in retirement accounts like IRAs, 401(k)s and 403(b)s, capital gains distributions have no immediate tax liability, so the ETF advantage is less relevant. But in taxable brokerage accounts holding US stocks, the mutual fund vehicle is at a disadvantage.

What Makes ETFs Special

ETFs generally avoid the tax liability problem because of their creation and redemption mechanism. ETF issuers create and redeem ETF shares through a specialized trader known as an authorized participant. APs transact with the ETF directly on behalf of investors, and these transactions often occur “in kind.” These transactions exchange stocks or bonds for ETF shares, which helps the ETF avoid cash transactions.

The in-kind redemption process gives ETFs their structural tax advantage. Instead of selling appreciated stocks to meet redemptions, the ETF can transfer stocks out of the portfolio through the AP. It does not have to sell shares of appreciated stock for cash, so the ETF avoids realizing capital gains. It can also help the portfolio manager remove positions that were purchased a long time ago and have accumulated a large, unrealized gain, reducing potential capital gains over time.

This does not eliminate taxes. ETF shareholders still owe capital gains taxes if they sell ETF shares at a gain in a taxable account. Instead, ETF investors have more control over when they choose to realize a taxable capital gain.

The table below looks at capital gains distributions in 2025 for some of the largest ETF providers. It highlights how powerful this structure can be compared with a regular mutual fund. Among the top five firms and nearly 1,000 US ETFs, just 5.0% paid a capital gains distribution in 2025, and only 2.75% had a distribution greater than 1.0% of their net asset value. That is a striking result compared with US mutual funds. Roughly 40% of them distributed capital gains in 2024.

Some ETFs may still distribute capital gains. Strategies that use options, swaps, futures, or other derivatives may not benefit from in-kind redemptions. Bond ETFs may have a very slight edge over their mutual fund counterparts, but their main distributions—coupon payments—remain taxable. Some international markets, like South Korea and China, can restrict in-kind transfers, which can force cash transactions. This may be especially relevant since the launch of ultrapopular (and speculative) Roundhill Memory ETF DRAM, as some of its top holdings are domiciled in markets that restrict in-kind redemptions.

ETFs Benefit Everyone

Investors often compare funds using total returns, which is useful to understand differences in how they perform. But it misses a major part of the investor experience: what investors actually keep after taxes. A fund may report a 10% total return in a given year, but the actual aftertax return can vary meaningfully based on income level, length of the holding period, and account type. ETFs’ tax efficiency matters because it can reduce the likelihood of unexpected capital gains distributions and give investors more control over when taxable gains are realized.

For high-income investors, the main benefit is avoiding unplanned and unwanted taxable events. These investors may already face elevated tax rates, so an unexpected capital gains distribution from a mutual fund can be particularly disruptive. In some cases, the investor may need to sell part of the investment simply to raise cash for the tax bill, creating an additional layer of disruption. ETFs’ tax efficiency can help reduce this risk. The benefit is not tax avoidance, but tax deferral: More capital can remain invested until the investor chooses to sell.

For investors with low or uneven income, the advantage is timing flexibility. A retiree, commission-dependent employee, or professional with variable compensation may have years when realizing gains is more tax-efficient and years when it is less attractive. Because an ETF investor generally controls when gains are realized, they may be able to pay the taxes during lower-income years and avoid adding taxable income in higher-income years. This timing benefit is especially useful because the tax impact of a gain can vary based on both the investor’s income level and the length of time the investment was held, as shown below.

For simplicity, the table above assumes the investor had no income outside of their capital gains and is a single filer. In every scenario, the investor pays less in taxes by realizing those capital gains after one year when they are realized as long-term gains. The difference becomes especially meaningful at higher income levels: A $700,000 short-term gain reaches the 37.0% ordinary income bracket, plus the 3.8% net investment income tax. It would be far superior to spread a large capital gain over multiple years for lower long-term rates, and lower tax rungs overall. For ETF investors, this reinforces the value of control. By reducing unexpected fund-level capital gains distributions, ETFs can help investors decide when to realize gains and, where possible, hold investments long enough to qualify for more favorable long-term tax treatment.

ETFs’ tax efficiency may be one of their most durable advantages that not everyone thinks about. In taxable US stock funds, ETFs give investors more control over when capital gains are realized. That control can reduce unwanted tax bills, improve aftertax outcomes, and allow compounding to work its magic.

Mutual funds remain important, especially in retirement accounts and in strategies where distributions can’t be avoided. Mutual funds may also remain useful for strategies that are capacity-constrained or not traded as frequently. For many investors, the ETF’s tax edge is difficult to ignore. Fees and transparency helped ETFs become popular. Tax efficiency may give it the extra boost it needs to overtake mutual funds as the dominant vehicle for diversified investing.