One major benefit of an ETF is the tax advantage it holds over a mutual fund. ETFs are more tax-efficient due to their construction and the way the IRS classifies them. Specifically, capital gain taxes are only realized on an ETF when the entire investment is sold whereas a mutual fund incurs capital taxes every time the assets in the fund are sold.
Mutual Fund Taxes
Whenever you sell an asset for a profit, the government wants its share of the pie. The tax on this profit is known as the capital gain tax. If you make money, the government makes money.
Since the assets in a mutual fund are actively traded by a fund manager, every time equities are sold for a profit, capital gain taxes must be paid. Over the course of time, that can add up to a lot of frequent tax incursions.
There are capital gain taxes to be paid on the profitable sale of an ETF also, but with a major difference. The capital gain tax on an asset in an ETF is only paid when the entire ETF sold, not while you are holding the ETF.
While ETF assets are not as actively traded as equities in mutual funds, there may be some stocks in the ETF that need to be changed or replaced due to readjustments. However, the taxes on any gains from the sales of these assets are delayed until the entire ETF is sold. Any time you can hold on to your money is a good time. A bird in the hand.
In conclusion, an ETF holds two major tax advantages over a mutual fund. Mutual funds usually incur more capital gains taxes than ETFs due the frequency of trading activity. Also, the capital gain tax on an ETF is delayed until the sale of the product, however a mutual fund incurs taxes during the life of the investment.
As with any investment, it's important to know all the implications that are involved. So before you get started with ETFs, make sure you understand how they are going to affect your tax return.