How ETFs can help improve tax efficiency
September 2026, Personal Finance
- Key Insights
-
- Exchange-traded funds (ETFs) can help minimize capital gain distributions because they trade primarily on an exchange and can meet certain redemptions in kind without selling securities.
- For long-term investors in taxable accounts, this can mean capital gains tax exposure is driven less by other shareholders’ activity and more by their own decisions about when to sell.
- Active ETFs can potentially enhance these benefits by using in-kind redemptions when making portfolio decisions, pursuing opportunities while limiting taxable events for shareholders.
For investors who own mutual funds in taxable accounts, an unwelcome surprise can arrive at year-end: a capital gain distribution and an associated tax bill, even though they didn’t sell a single share.
This is where ETFs can offer distinct tax advantages for buy and hold investors in taxable accounts. Their unique structure can help minimize capital gain distributions, meaning an ETF investor’s year-to-year capital gains tax exposure may be driven less by the trading activity of other shareholders and more by their own decisions about when to sell. This can provide greater flexibility over when gains are realized and the associated taxes are incurred.
That distinction matters most in taxable accounts. Mutual funds can still be a logical choice in tax-deferred accounts, such as Traditional individual retirement accounts (IRAs) and 401(k)s, where year-end capital gain distributions generally don’t create an immediate tax liability.1
How the ETF structure can lead to greater control over when gains are realized
Think of mutual funds and ETFs in a taxable account as two different ways of getting to the same destination: a city bus and a taxi.
The tax benefit in an ETF comes from what doesn’t have to happen. Because fewer securities may need to be sold inside the portfolio to accommodate other investors’ redemptions, ETFs have historically distributed fewer capital gains than mutual funds.3 That can leave taxable investors with greater control over when gains are ultimately realized.
ETFs can still distribute capital gains, and investors generally owe taxes when they sell ETF shares at a gain. The advantage isn’t that taxes disappear. It’s greater control over their timing.
Active management can add another dimension
Active ETF managers can take the tax-efficient features of the ETF structure a step further by using them as part of their investment process. They can make deliberate decisions about which securities or tax lots to transfer in kind, which to sell, and when to realize gains or losses.
The goal isn’t simply to minimize taxes in a given year. It’s to pursue the portfolio’s investment objectives while limiting unnecessary taxable events along the way. (See “How active managers can put the ETF structure to work.”)
How active managers can put the ETF structure to work4
|
Raise the portfolio’s cost basis |
Capture losses to offset gains |
Reposition without realizing gains |
|---|---|---|
|
Managers can transfer out securities with large embedded gains through in-kind redemptions rather than selling them. Removing these lower-cost-basis shares can raise the average cost basis of remaining holdings, potentially reducing gains if they are sold later. |
Managers can choose to sell securities that have declined in value, realizing losses that can help offset gains elsewhere in the portfolio. This can reduce the portfolio’s net realized capital gains. |
Managers can use in-kind redemptions to reduce or eliminate appreciated positions without selling them. This can help them reposition the portfolio while limiting capital gains realized along the way. |
How can this benefit an active ETF investor?
Consider two investors with taxable accounts. One invests $100,000 in a mutual fund and the other in an ETF. Both pursue similar active large-cap growth strategies and generate a 13% average annual return (pretax) over five years. At the end of five years, both investors have more than $183,000 in their accounts. (See Figure 1.)
Growth and tax impact over five years
(Fig. 1) Both funds are similarly managed, active, large‑cap growth strategies in a taxable account with a 13% average annual return (pretax).
Illustration Assumptions: This hypothetical is for illustration purposes only and does not reflect actual investment results or guarantee of future results. Respective gross annual returns in years 1–5 for both the mutual fund and ETF: 30%, 15%, ‑35%, 40%, 35%. Average annual return: 13%. On reinvested capital gain distributions, the short-term tax rate is 25% and the long-term tax rate is 15%. Ninety-five percent (95%) of capital gain distributions are long term. Over the investment period, the percentage of returns distributed at year‑end is approximately 50% for the mutual fund and 0% for the ETF. As is the case historically, ETFs may distribute zero or minimal capital gains, but this is not guaranteed. Because dividend and interest income must be paid out by both mutual funds and ETFs and cannot be minimized by ETF in-kind redemptions, they have been excluded from this comparison.
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Same destination, but two very different tax journeys:
|
Mutual fund investor |
ETF investor |
|---|---|
|
Over five years, the mutual fund paid $41,500 in capital gain distributions, resulting in $6,400 in tax bills for the investor, even though they hadn’t sold any shares. |
Over the same period, the ETF made no capital gain distributions, so the investor paid $0 in taxes on capital gain distributions during the holding period. |
The result:
While both investors ended up with roughly the same investment balance, their tax experiences were very different. The mutual fund investor experienced varying capital gain distributions and less predictable annual tax bills. (See Figure 2.)
The mutual fund investor had less predictable taxable distributions, resulting in annual tax bills
(Fig. 2)
|
Mutual fund |
Highest year |
Lowest year |
Average per year |
Total |
|---|---|---|---|---|
|
Capital gain distributions |
$16,400 |
$1,600 |
$8,300 |
$41,500 |
|
Taxes paid from other savings |
$2,500 |
$200 |
$1,300 |
$6,400 |
In this scenario, the mutual fund investor had enough money in other savings to pay those taxes out of pocket, allowing the full capital gain distributions to be reinvested. Without that available cash, the investor may have needed to set aside a portion of the distributions to pay the taxes, leaving less money invested and able to compound over time.
The ETF, by comparison, made no capital gain distributions during the five-year period. With no distributions to reinvest, the ETF investor ended the period with a larger unrealized gain ($83,700 versus $42,200 for the mutual fund investor). Those gains haven’t disappeared, but the investor can decide when to realize them and incur the associated taxes.
More control along the way
Mutual funds and ETFs can both help investors reach their long-term financial goals, but the tax journey along the way can look very different. For investors in taxable accounts, the ETF structure can help reduce the potential for unexpected tax bills triggered by other shareholders’ actions and provide greater flexibility over when gains are realized. That flexibility can make it easier to consider taxes alongside other important investment and financial planning decisions.
For active ETFs, their unique structure can offer another benefit. Portfolio managers may be able to use the ETF’s in-kind mechanism as part of their investment process, pursuing opportunities and repositioning portfolios while limiting taxable events along the way.
Ultimately, tax efficiency isn’t about avoiding taxes altogether. An ETF may accumulate larger unrealized gains, but greater control over when those gains are realized can help investors coordinate taxable income with their broader financial and retirement plans.
Lindsay Theodore, CFP®
Thought Leadership Senior Manager
Is your portfolio tax-efficient?
1 Year-end distributions are not taxable for mutual funds held in a tax-deferred account, such as an IRA or 401(k). If held in a tax-deferred account, ordinary income taxes are owed only when payments are withdrawn from the account.
2 Although the in-kind creation and redemption process plays a key role in ETF tax efficiency, certain securities (e.g., fixed income, international equities) may be less conducive to in-kind transfers.
3 Source: Morningstar, “Few ETFs Project Capital Gains Distributions in 2025: Key Takeaways for Investors,” December 2025. ETFs may distribute capital gains, and tax efficiency can vary by strategy and holdings.
4 Though these strategies are available to ETF managers, the degree to which they are utilized can vary across ETF issuers, managers, and strategies.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of September 2026 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a guarantee or a reliable indicator of future results. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
ETFs are bought and sold at market prices, not NAV. Investors generally incur the cost of the spread between the prices at which shares are bought and sold. Buying and selling shares may result in brokerage commissions which will reduce returns.
Risks: All investments are subject to market risk, including the possible loss of principal. Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives.
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