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Concept · Funds, wrappers and fees

What is in-kind redemption, and why does it make ETFs tax-efficient?

Direct answer In-kind redemption is paying a departing ETF investor in stock rather than cash. Under IRC §852(b)(6) the fund recognizes no gain on the stock it hands over, so the manager gives away the lowest-basis lots and the embedded gain leaves the fund untaxed. Mutual funds redeem in cash, must sell, and distribute the gains.

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

The result over ten years: 0.7% a year of tax drag for the average stock ETF against 1.9% for the average stock mutual fund. Read why ETFs pay less tax than mutual funds.

Sources

  1. IRC §852(b)(6)law.cornell.edu
  2. SEC Rule 6c-11, custom basketslaw.cornell.edu

Used in

ETF share classes: the patent that expired One firm held a patent on attaching an ETF share class to a mutual fund until May 2023. Since November 2025 the SEC has let others do it, and the funds that get one stop paying out gains. One rule holds up the ETF tax advantage, and Treasury is looking at it As of September 2026 nothing pending changes the ranking of the levers. One live item: Treasury has said it is examining the in-kind mechanism behind every ETF's tax edge. A dated watchlist. Section 351: moving a portfolio into an ETF without selling Since December 2024, 113 ETFs have launched by taking in investors' stock portfolios for shares, no gain recognized, about $21 billion so far. The two tests, and why the IRS has not said yes. Why ETFs pay less tax than mutual funds The average stock mutual fund lost 1.9% a year to tax over the last decade; the average stock ETF lost 0.7%. The gap comes from one line in the tax code, not from smarter managers.

Related concepts

ETF share classTax cost ratioSection 351 seedingTax drag

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