Exchange-traded funds (ETFs) are known for their tax advantages, which can be especially beneficial for investors during certain times.

• Mutual funds may result in higher annual tax bills for investors compared to exchange-traded funds.
• ETF managers can generally avoid distributing capital-gains taxes to shareholders.
• U.S. stock holders in non-retirement accounts are likely to receive the most tax savings.

Experts advised that investors can typically minimize their tax losses in their portfolio by opting for exchange-traded funds instead of mutual funds.

ETFs have unique tax benefits that surpass those of mutual funds, according to Bryan Armour, Morningstar's director of passive strategies research for North America and editor of its ETFInvestor newsletter, in a statement made earlier this year.

But certain investments benefit more from that so-called "magic" than others.

Tax savings are moot in retirement accounts

ETFs' tax savings are typically greatest for investors in taxable brokerage accounts.

Retirement accounts, such as those in a 401(k) plan or individual retirement account, are already tax-advantaged, with contributions growing tax-free. Therefore, ETFs and mutual funds are tax-neutral in terms of retirement savings, experts said.

The tax advantage is particularly beneficial to the non-IRA account, according to Charlie Fitzgerald III, a certified financial planner in Orlando, Florida, and a founding member of Moisand Fitzgerald Tamayo.

He stated that a standard mutual fund would not be able to achieve the level of tax efficiency that you will have.

The 'primary use case' for ETFs

ETFs are typically more tax-efficient than mutual funds due to their structure that minimizes capital gains taxes within the fund.

Those who make a profit from selling investments are likely aware of the tax implications.

Capital gains generated by mutual fund managers are distributed to investors and divided equally among shareholders, who pay taxes on those gains at their respective income tax rate.

ETFs have a unique structure that allows their managers to typically avoid paying capital gains taxes.

ETFs are a primary use case for asset classes that generate large capital gains relative to their total return, according to Armour, who told CNBC. However, an investor who sells their ETF for a profit may still owe capital gains tax.

Why U.S. stocks 'almost always' benefit from ETFs

Experts stated that U.S. stock mutual funds typically generate the highest capital gains compared to other asset classes.

According to Armour, citing Morningstar data, over 70% of U.S. stock mutual funds experienced capital gains between 2019 and 2023. In contrast, less than 10% of U.S. stock ETFs achieved the same.

Having your stock portfolio in an ETF rather than a mutual fund is usually beneficial in a non-retirement account, according to Armour.

According to Armour, U.S. "growth" stocks, a stock sub-category, experienced more than 95% of their total return from capital gains in the five years through September 2024. This makes them the greatest beneficiary of ETFs' tax efficiency.

Capital gains account for approximately 85% to 90% of the returns for both large-cap and small-cap "core" stocks, according to Armour.

Dividends, which are taxed differently than capital gains in an ETF, account for about 25% to 30% of value stocks' returns, making them the "least beneficial" U.S. stocks in an ETF, according to Armour.

"They still benefit substantially, though," he said.

ETF dividends are taxed based on the length of time the investor has held the fund.

ETFs are typically more suitable for actively managed stock funds, according to Fitzgerald.

Active managers often distribute more capital gains than passive index trackers, as they frequently buy and sell positions in an attempt to outperform the market, according to him.

Strategic beta funds can cause passively managed funds to trade frequently, as Armour stated.

Bonds have a smaller advantage

According to Armour, ETFs cannot eliminate tax liabilities resulting from currency hedging, futures, or options.

International-stock ETFs, such as those investing in Brazil, India, South Korea, or Taiwan, may have their tax benefits reduced due to the tax laws of various nations.

Bond ETFs have a smaller advantage over mutual funds, Armour stated, as most bond funds' returns come from income rather than capital gains.

Fitzgerald says he favors holding bonds in mutual funds rather than ETFs.

However, his reasoning isn't related to taxes.

When the stock market experiences high volatility, causing fear selling and a dip, Fitzgerald frequently buys stocks at a discount for clients by selling bonds.

During times of market volatility, the price of a bond ETF tends to diverge more from the net asset value of its underlying holdings compared to a mutual fund.

He stated that the bond ETF is often sold at a lower price compared to a similar bond mutual fund, which can reduce the overall strategy's benefit if the bond position is sold for less money.