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.

From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income.

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.

ETFs structured as open-end funds, also known as '40 Act funds, are taxed up to the 23.8% long-term rate or the 40.8% short-term rate when sold.

Distributions and your taxes

If you have mutual funds in these types of accounts, you pay taxes only when earnings or pre-tax contributions are withdrawn. This information will usually be reported on Form 1099-R.

Please note that when you convert your current asset base into an ETF you do not ELIMINATE taxes, you simply carry over your basis from your underlying investments, and your old basis is now the basis in your ETF shares.

Systematic Withdrawal Plan (SWP): Set up an SWP to automatically redeem your mutual fund units regularly. By keeping withdrawals below Rs. 1 lakh per year, you may avoid LTCG tax altogether.

Mutual funds are not taxed twice. However, some investors may mistakenly pay taxes twice on some distributions. For example, if a mutual fund reinvests dividends into the fund, an investor still needs to pay taxes on those dividends.

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.

How long should you hold an ETF? ›

Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.

How are ETFs and mutual funds different? How are they managed? While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed.

Use tax-advantaged accounts

Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account. You'll just pay income taxes when you withdraw money from the account.

Unlike ETFs, mutual funds can be purchased in fractional shares or fixed dollar amounts. ETFs typically have lower expense ratios than mutual funds because they offer minimal shareholder services. Though mutual funds may be slightly more costly, fund managers provide support services.

Because the ETF is a separate legal entity from the issuer that manages it, the ETF will control all the assets in its portfolio up until the date set for its liquidation, at which point the manager will sell the assets and distribute the proceeds to investors.

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.

ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments.

Through everyday redemptions and heartbeat trades, equity ETFs are able to make tax-free portfolio adjustments and avoid generating capital gains until their shareholders sell their shares.

Usually, ETFs have much lower fees and higher daily liquidity compared to mutual fund shares. ETF can be used for purposes like Hedging, Equitizing Cash, and for Arbitrage. ETF shareholders get a small portion of the gained profits, i.e, the dividends paid and interest earned.