Why ETFs pay less tax than mutual funds

Two funds hold the same 500 stocks. One is a mutual fund, one is an ETF. Over ten years the mutual fund’s investors gave up 1.9% a year to tax on the fund’s distributions; the ETF’s investors gave up 0.7%. Same stocks, same returns before tax, 1.2 points a year of difference after it.

Where a mutual fund’s tax bill comes from

When you hold a fund, you pay tax on two things: what you get when you sell your shares, and what the fund hands out along the way. The second part is the problem. A fund has to sell stocks whenever investors redeem, or whenever it rebalances, and every sale of an appreciated stock creates a gain. By law the fund must distribute its net gains to shareholders each year, and shareholders pay tax on them whether or not they sold anything themselves.

In 2025 about 72% of US stock mutual funds paid out a capital gain. In 2023 the figure for active mutual funds was 34%, against 4% for active ETFs running the same kinds of strategies.

The one line that changes it

An ETF does not sell stocks to pay off a departing investor. It hands the stocks over. A large trading firm brings ETF shares back to the fund and receives a basket of the underlying stocks in return, in kind. The tax code says a fund recognizes no gain on stock it distributes this way. So the ETF’s manager gives away the lots with the biggest embedded gains, the gains leave the fund untaxed, and nothing is distributed to the shareholders who stayed.

1. A trading firm redeems ETF shares It returns, say, 50,000 ETF shares to the fund.
2. The fund pays in stock, not cash It hands over a basket of the underlying stocks, choosing the lots bought at the lowest prices.
3. No gain is recognized IRC §852(b)(6): a fund recognizes no gain on securities distributed in kind on redemption. The embedded gain leaves with the stock.
4. The fund's remaining lots have a higher basis Rebalances and later sales produce smaller gains. Little or nothing is distributed.

Two refinements make this run continuously rather than occasionally. Since 2019, ETF managers can choose which lots go into a redemption basket. And on rebalance days, some ETFs arrange a large creation followed a day or two later by a redemption, so the stocks being dropped from the index leave in kind rather than being sold. The trade pattern looks like a heartbeat on a chart, which is what the industry calls it.

What the ETF still pays

Dividends. An ETF must pass through the dividends its stocks pay, and the investor pays tax on them each year. On a 1.3% yield at the 35% rate that is about 46 basis points a year, most of the ETF’s 0.7% drag. No wrapper removes it; the dividend gets its own short read in this topic.