Can You Buy into an ETF and Defer Taxes?

Exchange-traded funds (ETFs) can be tax-efficient investments, but they are not tax-free. You don’t owe taxes when you buy shares, but you may owe tax on dividends or capital gains if they occur. ETFs use a structure that helps reduce taxable events when compared with mutual funds, especially through the in-kind redemption process. However, taxes still apply when you sell your shares or receive income from the fund. How much you owe depends on the type of ETF, your investment account and your overall strategy. A financial advisor could provide additional insights into how ETFs fit into your tax strategy.

How ETFs Are Taxed

When you sell ETF shares at a profit, you’ll owe capital gains tax on that profit. The tax rate depends on how long you held the investment. If you owned the ETF for more than a year, you’ll pay the lower long-term capital gains rate (0%, 15%, or 20%, depending on your income). Profit on holdings under a year old count as ordinary income at your regular tax bracket rate.

Some ETFs generate income through dividend-paying stocks. Most domestic stock ETFs distribute qualified dividends, while certain specialty ETFs may distribute non-qualified dividends. Qualified dividends receive preferential tax treatment similar to long-term capital gains. Non-qualified dividends are taxed at your ordinary income rate.

The IRS taxes bond ETF distributions as ordinary income, too. This makes bond ETFs potentially less tax-efficient than stock ETFs when held in taxable accounts. Municipal bond ETFs offer an exception, as their interest payments are typically exempt from federal taxes and sometimes state taxes if you reside in the issuing state.

Does Buying ETFs Defer Any Tax Liability?

An investor researching whether buying ETFs defer tax liability.

ETFs don’t defer all taxes, but they can reduce how often you owe them. You don’t pay tax just for buying an ETF, and you generally won’t owe capital gains tax until you sell your shares. However, any dividends paid by the ETF may be taxable in the year you receive them, even if you reinvest those dividends. The increase in value of your ETF shares over time isn’t taxed until the shares are sold.

One reason ETFs are considered tax-efficient is because of how they’re structured. Through a process called in-kind creation and redemption, large investors can trade ETF shares for the underlying securities without creating taxable events. This process helps limit capital gains distributions passed on to investors. While you don’t participate in these trades directly, you benefit from the lower chance of receiving unexpected taxable gains each year.

Tax Benefits of Investing in ETFs

If you’re interested in buying ETFs, here are four tax benefits to keep in mind:

Tax-efficient structure: ETFs typically generate fewer capital gains distributions than mutual funds. While investors can’t control or defer any capital gains that the ETF distributes, they do have control over when they sell their ETF shares, which lets them decide when to realize their own capital gains.
Lower turnover rates: Many ETFs, especially those tracking broad market indexes, have lower portfolio turnover than actively managed funds. This reduced trading activity gives investors greater control over when to trigger tax liabilities.
Capital gains treatment: When you do sell ETF shares that you’ve held for more than a year, any profits are typically taxed at the long-term capital gains rate. These low rates can potentially save investors significant amounts on their tax bills.
Tax-loss harvesting opportunities: ETFs make it easier to implement tax-loss harvesting strategies. Investors can sell underperforming ETFs to realize losses for tax purposes while maintaining similar market exposure through alternative ETFs.

Tax Strategies for ETF Investments

When market values decline, consider selling ETF positions at a loss to offset capital gains elsewhere in your portfolio. You can then reinvest in a similar (but not identical) ETF to maintain market exposure while avoiding wash sale rules. This strategy works well because the ETF universe offers many comparable alternatives tracking similar indexes.

Additionally, you may want to consider which accounts hold your ETFs. Place tax-inefficient ETFs (like those holding bonds that generate regular taxable income) in tax-advantaged accounts like IRAs or 401(k)s. Meanwhile, tax-efficient ETFs that focus on long-term growth with minimal distributions might be better suited for taxable accounts. This strategic asset location can significantly reduce your overall tax burden.

Avoid buying ETFs just before they make distributions. Research distribution schedules and consider delaying purchases until after distribution dates to prevent receiving an immediate taxable event. This simple timing adjustment can prevent you from paying taxes on gains that occurred before you owned the investment. As with any investment decision, consider working with a tax consultant to determine how these benefits apply to your specific financial situation.

Bottom Line

An investor checking the performance of her portfolio.

While you can’t completely avoid taxes with ETFs, these investment vehicles do offer significant tax advantages when compared with mutual funds. ETFs generally create fewer taxable events due to a unique creation and redemption process that helps limit taxable events inside the fund.

Tax Planning Tips for Investments

A financial advisor can help you manage your tax liability on your investment portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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