Exchange-traded funds (ETFs) have long been touted for their tax advantages over mutual funds. The difference lies in the structure of these investment vehicles, which can have a significant impact on the tax bill incurred by investors.

ETFs and mutual funds both consist of baskets of stocks, bonds, and other financial assets managed by professionals. However, ETFs have a unique “tax magic” that sets them apart from mutual funds, according to Bryan Armour, the director of passive strategies research for North America at Morningstar.

One of the key advantages of ETFs is their ability to minimize capital gains distributions, which are taxes owed on investment profits. Fund managers can generate these taxes within a fund when buying and selling securities, passing them on to shareholders. However, ETFs utilize a mechanism called “in-kind creations and redemptions,” which allows for tax-free trades for many ETFs. This mechanism involves large institutional investors creating or redeeming ETF shares directly with the ETF provider.

This tax advantage is particularly noticeable for stock funds, with over 60% of stock mutual funds distributing capital gains in 2023 compared to just 4% of ETFs. Morningstar estimates that less than 4% of ETFs will distribute capital gains in 2024, highlighting the tax efficiency of these investment vehicles.

It’s important to note that this tax advantage is most relevant for investors holding funds in taxable accounts, as retirement accounts like 401(k) plans and individual retirement accounts already come with tax benefits.

While ETFs generally offer tax advantages over mutual funds, there are exceptions. Certain ETF holdings, such as physical commodities and derivatives like swaps and futures contracts, may not benefit from in-kind transactions. Additionally, some countries may treat in-kind redemptions of securities domiciled in those countries as taxable events.

In summary, ETFs offer significant tax advantages for investors in taxable accounts, providing greater tax efficiency compared to mutual funds. However, it’s essential to consider the specific holdings and potential tax implications when choosing between ETFs and mutual funds for your investment portfolio.