Mutual funds, ETFs, and capital gains distributions

Many mutual funds and ETFs track market capitalization-weighted indexes. It’s an investment strategy that tends to lead to minimal buying and selling—particularly for equity index funds and ETFs. That, combined with the longer-term investor base, helps reduce portfolio turnover and as such, index funds usually distribute fewer capital gains.

Similarly, for mutual funds and ETFs employing active investment strategies, lower portfolio turnover generally leads to fewer capital gains.

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.

Even the most tax-efficient mutual funds and ETFs may nevertheless occasionally distribute capital gains as their holdings appreciate over the long term. Global equities have generally enjoyed significant gains, with only brief interruptions, for well over a decade. As a result, many mutual funds and ETFs hold securities with previously unrealized capital gains that may be realized through the normal course of portfolio operations, such as when an index rebalance requires appreciated securities to be sold.

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

Distributions by 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 longer than one year are taxed more favorably as long-term capital gains. These gains are taxed at 0%, 15%, or 20% in 2024, depending on an investor’s level of taxable income.

When a mutual fund or ETF held in a taxable account distributes capital gains to shareholders, the taxes on those gains are due for that tax year rather than at a future time when an investor sells the shares.

Capital gains distributions generally have no impact on the performance of a fund or ETF. Once the capital gains are distributed, the price of the fund or ETF is typically reduced by the amount of the distribution.

There are some ways to help mitigate the impact of capital gains:

• Distributions may provide an opportunity to efficiently rebalance your portfolio allocation, fulfill future cash-flow needs, top off your savings, or meet gifting
  needs—this is where a financial advisor can help.
  
  
• If you reinvest your distributions, you can expect to see a compounding effect on that investment over the long term.
  
  
• Looking beyond taxable accounts, investment earnings—including capital gains distributions—can benefit from tax-deferred or tax-free treatment when held in IRAs, 401(k) plans, and Roth IRAs, so long as certain conditions are met.¹ Diversifying where you hold your investments can be as simple as splitting contributions among different account types.