When it comes to investing in ETFs (Exchange-Traded Funds) and mutual funds, understanding how they’re taxed is important. Here’s a breakdown of the key differences in simple terms.
How Are ETFs and Mutual Funds Taxed?
- Capital Gains:
- ETFs: Generally, ETFs are more tax-efficient because they don’t often have capital gains distributions. This means you won’t pay taxes on gains unless you sell your shares for a profit.
- Mutual Funds: Mutual funds frequently have capital gains distributions, which are taxed even if you don’t sell your shares. This happens because mutual funds buy and sell securities more often, creating more taxable events.
- Tax Rates:
- Both ETFs and Mutual Funds: Long-term capital gains (from assets held for more than a year) are taxed at 0%, 15%, or 20%, depending on your income level. For example, in 2024, single filers won’t pay any capital gains tax if their total taxable income is $47,025 or less.
- Dividend Income:
- Both ETFs and Mutual Funds: Dividend income is taxed, but qualified dividends are taxed at the same lower rates as long-term capital gains. To qualify, you must have held the shares for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
Key Points to Remember
- ETFs are generally more tax-efficient because they have fewer capital gains distributions, which means less tax to pay.
- Mutual funds can have more taxable events due to frequent buying and selling of securities, which increases capital gains distributions.
- Both ETFs and mutual funds are taxed on dividends and capital gains, but ETFs tend to have fewer taxable events.
Conclusion
In summary, ETFs are generally more tax-efficient than mutual funds because they have fewer capital gains distributions. This means you pay less tax unless you sell your shares for a profit. Understanding these differences can help you make informed decisions about your investments.