Mutual funds and ETFs: Understanding capital gains

Many mutual funds and ETFs track market capitalization-weighted indexes. This approach generally results in lower portfolio turnover because index funds tend to buy and sell securities less frequently. Lower portfolio turnover in mutual funds and ETFs can help reduce realized capital gains and minimize the potential for a distribution.

ETFs have additional tax advantages. Because ETFs trade on exchanges much like individual stocks do, most of the trading in ETFs takes place between investors on the secondary market, with no impact on the ETFs’ underlying securities. A much smaller share of ETF trading occurs on the primary market, where ETF shares are exchanged through transactions with financial institutions known as authorized participants, usually for a basket of securities rather than cash. Such “in-kind” transactions are not considered taxable events and thus also contribute to ETFs’ tax efficiency.

Investors may receive a capital gains distribution even if they haven't sold any shares of a mutual fund or ETF. Such distributions occur when a fund realizes gains from selling appreciated securities during normal portfolio operations, such as index rebalancing or changes in holdings. Even highly tax-efficient funds may occasionally distribute capital gains, especially after extended periods of market appreciation that leave many portfolios with substantial unrealized gains.

While international mutual funds and ETFs can be tax-efficient, they may be more likely to distribute capital gains than many U.S. equity funds. Differences in market structures and trading practices across countries can make it more difficult to manage taxable gains. In addition, some international indexes experience higher portfolio turnover, which can increase the likelihood of capital gains distributions. 

How capital gains distributions are taxed is determined by how long the mutual fund or ETF has held the securities.

Distributions by mutual funds and ETFs are considered to be short-term capital gains if the fund or ETF held the securities for less than one year. These gains are taxed at the same rate as an investor’s ordinary income, which could be as high as 37%.

Meanwhile, distributions on securities that have been held for more than one year are taxed more favorably as long-term capital gains. These long-term gains are generally taxed at lower rates, depending on an investor’s level of taxable income.

Capital gains distributions are generally announced and distributed to shareholders at the end of the calendar year, with estimates often announced in the fall. When a mutual fund or ETF held in a taxable account distributes capital gains to shareholders, any taxes owed on those gains are generally due for that tax year rather than when an investor later sells their shares.

Capital gains distributions generally do not affect a fund's total return. When a capital gains distribution is paid, the fund's net asset value is typically reduced by the amount of the distribution. As a result, the distribution itself does not increase the overall value of an investor's holdings, although investors in taxable accounts may owe taxes on the distribution.

Capital gains distributions may create a tax obligation in taxable accounts, but they are a normal part of investing and can occur even in highly tax-efficient funds and ETFs. While tax efficiency is an important consideration, investors should evaluate funds and ETFs based on their overall investment objectives, costs, and long-term role in a portfolio.