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 ten years ending 2021, 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.