Many mutual funds lack the "tax magic" offered by exchange-traded funds.

• Shareholders can benefit from capital gains taxes generated by fund managers through buying and selling securities.
• Fewer exchange-traded fund investors receive an annual tax bill compared to those holding mutual funds.
• Experts stated that ETFs receive these tax benefits because of "in-kind" transactions.

Exchange-traded funds (ETFs) can help investors avoid tax bills compared to mutual funds, which are less tax-efficient, according to investment experts.

ETFs and mutual funds are similar in that they are composed of a variety of financial assets, but they differ in their legal structure, giving ETFs a unique "tax advantage" over mutual funds, according to Bryan Armour, the director of passive strategies research for North America and editor of the ETFInvestor newsletter at Morningstar.

That tax savings relates to annual capital gains distributions within the funds.

Capital gains taxes are owed on investment profits.

When fund managers buy and sell securities, they can generate taxes within a fund, which are then passed along to all shareholders, who owe a tax bill even if they reinvest those distributions.

The tax advantage of ETFs is due to "in-kind creations and redemptions," which allows for tax-free trades for many ETFs, experts explain. The in-kind transaction mechanism of ETFs is intricate, with large institutional investors called "authorized participants" directly creating or redeeming ETF shares with the provider.

The tax advantage is generally most apparent for stock funds, they said.

In 2023, more than 60% of stock mutual funds distributed capital gains, while only 4% of ETFs did the same, according to Morningstar.

According to Morningstar, only a small percentage of ETFs are predicted to distribute capital gains in 2024. However, this information is not yet available for mutual funds.

This tax advantage applies only to investors with funds in taxable accounts, according to experts.

Experts stated that for retirement account investors, such as those with a 401(k) plan or individual retirement account, it is not necessary to consider tax benefits since they already come with them.

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.

However, ETFs don't always have a tax advantage, experts said.

In-kind transactions may not benefit certain ETF holdings, Armour stated.

Certain financial instruments, including both physical commodities and their derivatives such as swaps, futures contracts, currency forwards, and certain options contracts, were mentioned by him.

Certain nations, including Brazil, China, India, South Korea, and Taiwan, may consider in-kind redemptions of securities domiciled in those countries as taxable events, according to him.