How are ETFs tax efficient?

• When investing for retirement, it’s critical to stay focused on after-tax returns. ETFs are generally tax efficient, which can help investors keep more of what they earn.
• Low turnover and insulation from the actions of other shareholders are keys to the tax efficiency of ETFs.
• ETFs held 26% of U.S. managed fund assets but accounted for less than 1% of capital gains distributions in 2022.¹

You’ve probably learned that keeping fees low can be a big driver of successful investing. And while keeping fees low is important, taxes may actually be more harmful to long-term returns than fund management fees.

For example, the average annual tax cost for active U.S. large-cap mutual funds was 2.12% for the 10 years ending in 2022, more than double their average annual expense ratio of 0.85%.² And while 2% may not seem like a big tax burden, a hypothetical $100,000 portfolio would have suffered a tax drag of over $45,000 after a decade of 10% average annual returns.³

Taxes can cost more than you think

Hypothetical growth of $100,000 over 10 years at 10% return

ETFs can help shield investors from capital gain distributions, or the periodic distributions funds make to shareholders on realized profits from the sale of underlying assets. ETFs held 26% of U.S. managed fund assets at the end of 2022 but accounted for less than 1% of capital gains distributions.⁴

Two key reasons explain why ETFs can be so tax efficient: Low turnover and ETF shareholders are insulated from the actions of other investors.

The vast majority of ETFs are index funds, which typically trade less frequently than actively managed funds. Low turnover means fewer sales of stocks that have risen in price, resulting in the generation of fewer realized capital gains. Thus, ETF owners are likely to incur capital gains taxes only when they sell the investment.

In addition, investors buy and sell ETF shares with other investors on an exchange. As a result, the ETF manager doesn't have to sell holdings — potentially creating realized capital gains — to meet investor redemptions. If you're invested in an ETF, you get to decide when to sell, making it easier to avoid those higher short-term capital gains tax rates. For the five years ending 2022, no iShares U.S. style box ETFs paid a capital gain.⁵

Certain traditional mutual funds can be tax efficient and, of course, ETF shareholders can incur tax consequences when they sell shares, but that tax consequence is not passed on to other ETF shareholders.

For investments in so-called qualified accounts like a 401(k) or IRA, you’re insulated from the impact of taxation. But for investors with taxable (non-qualified) accounts, owning cost and tax-efficient iShares ETFs can help improve your long-term investment returns, allowing you to keep more of what you earn.

Combining a low turnover strategy with a tax-efficient structure gives you more control over when to pay taxes on your ETF’s gains. And for long-term investors, this can mean more money in your account working for you rather than the IRS.

Where does “tax cost” come from?