How mutual funds & ETFs are taxed | Vanguard (2024)

FAQs

How mutual funds & ETFs are taxed | Vanguard? ›

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.

Like income from the sale of any other investment, if you have owned the mutual fund shares for a year or more, any profit or loss generated by the sale of those shares is taxed as long-term capital gains. Otherwise, it is considered ordinary income.

Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.

In these cases, investors don't have to pay extra taxes when a mutual fund they own converts to an ETF. Brokerage account holders simply get the value of their mutual fund investment transferred tax-free into the ETF version. The new ETF has the same managers and portfolio that the mutual fund had.

The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

The tax rate (and in turn the tax on mutual funds) depends on the type of distribution and other factors. That means you may owe tax on mutual funds you've invested in — even if you haven't sold any of the shares or received any cash from your investments.

Distributions and your taxes

If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

ETFs are structured in a way that avoids taxable events for ETF shareholders. ETFs can avoid the wash sale rule because ETFs typically are an index for a sector or a group of stocks and are not "substantially identical" to a single stock.

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.

Mutual funds are usually actively managed, although passively-managed index funds have become more popular. ETFs are usually passively managed and track a market index or sector sub-index. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.

Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often.

Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.

Key Takeaways. Mutual funds with dividend distributions can bring in extra income, but they are also typically taxed at the higher ordinary income tax rate.

Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ETFs are traded on the stock exchange like an individual stock, which means that investors may have to pay a real or virtual broker in order to facilitate the trade.