ETF tax efficiency: What it is & why it matters

When choosing investments, it’s natural to focus on returns and expenses. Performance is easy to track, returns feel like a clear measure of success, and fees or expenses reduce total return. But over time, taxes can quietly take a meaningful bite out of those gains and significantly impact what you keep.

Exchange-traded funds (ETF) are generally more tax-efficient than mutual funds because of a structural feature called in-kind redemption, which helps the fund avoid triggering capital gains for shareholders. In practice, that means fewer surprise tax bills and more control over when you pay taxes.

ETF tax efficiency refers to how well an ETF minimizes taxable events, especially capital gains distributions, so more of your returns stay invested and compounded over time. A big reason for that is how ETFs handle buying and selling behind the scenes. They can add and remove shares without having to sell holdings, which helps avoid triggering taxes along the way.

That might not sound dramatic at first, but the impact builds over time. The less you pay in taxes, the more stays in your account, continuing to grow. At the same time, tax efficiency isn’t a reason to choose an investment on its own.

In this guide, we’ll break down how ETF tax efficiency works, why it tends to give ETFs an edge over mutual funds and how to use it as part of a smarter investing strategy.

Even with their advantages, ETFs aren’t tax-free. But compared to many other investments, you generally have more control over when and how those taxes appear. Here’s a brief look at what you can expect.

When you sell ETF shares, you’ll owe capital gains tax if the value has increased.

• Short-term gains (held for one year or less): taxed as ordinary income
• Long-term gains (held longer than one year): taxed at lower capital gains rates

One of the key advantages of ETFs is that you decide when to sell, giving you more control over when those taxes are triggered.

ETFs may distribute dividends from the underlying holdings.

• Qualified dividends: taxed at lower long-term rates
• Nonqualified dividends: taxed as ordinary income

Bond ETFs distribute dividends, which are typically taxed as ordinary income.

Although less frequent, ETFs still can distribute capital gains, usually at year-end.

The difference is consistency. Compared to mutual funds, these distributions are far less common, which means you’re less likely to face an unexpected tax bill without taking action yourself.

Some ETFs have unique tax rules:

• Physical metal ETFs: may be taxed at collectibles rates
• Commodity ETFs: often follow 60/40 tax treatment
• ETNs (exchange-traded notes): typically don’t distribute gains while held

The takeaway: ETFs give you more control than most fund structures, but taxes still depend on what you own and how long you hold it.

No, not all ETFs are created equal when it comes to tax efficiency. How a fund is managed, what it holds and how its underlying market operates all affect how much tax exposure gets passed on to you. 

These are typically the most tax efficient. They combine low turnover with consistent use of in-kind redemptions, which helps limit capital gains distributions. For many investors, broad index ETFs set the standard for tax-efficient investing.

Active ETFs are increasingly tax efficient. Skilled managers can use the in-kind process to remove appreciated securities from the portfolio, reducing taxable gains. At Thrivent, for example, all ETFs are actively managed. While active ETFs may generate more internal activity than index funds, they still can be more tax-efficient than traditional active mutual funds.

These are generally less tax efficient. Interest income, categorized as dividends for ETFs and mutual funds, is taxed as ordinary income, regardless of structure. So even if capital gains are limited, you’ll still face ongoing tax exposure related to the dividends paid. This is one reason many investors prefer to hold bond funds in tax-advantaged accounts.

Some markets restrict in-kind transfers of securities. In those cases, funds may need to sell holdings, which can trigger gains and reduce tax efficiency. The result can vary depending on where the fund invests.

These tend to be tax-inefficient due to heavy use of derivatives, which don’t benefit from in-kind redemption. They’re typically designed for short-term trading, not long-term, tax-efficient investing.

Some commodity funds use futures contracts, which are taxed under a 60/40 rule. That's 60% long-term and 40% short-term, regardless of how long you hold them. This blended treatment can reduce their overall tax efficiency compared to traditional equity ETFs.

The impact of tax efficiency may seem small year to year, but it adds up. Research from 2025 found that ETF tax efficiency has improved after-tax returns by about 1.05% annually compared to mutual funds in recent years.

That’s not trivial. Over decades, an extra 1% per year can significantly increase your ending portfolio value. The data shows how consistently that advantage plays out. In 2025, only 6% of equity ETFs paid capital gains distributions, compared to 57% of equity mutual funds.

A few strategic moves can help you maximize ETF tax advantages.

For example, consider holding ETFs in taxable accounts, aim to invest for the long term to benefit from lower capital gains rates, and consider tax-loss harvesting during market dips to offset gains. Just keep in mind that dividends are still typically taxable, even with ETFs.

Where you hold an investment matters as much as what you hold.

• Place tax-efficient ETFs (like broad equity index funds) in taxable accounts, where their structure helps reduce ongoing taxes.
• Hold less tax-efficient assets (like bonds or REITs) in tax-advantaged accounts such as IRAs or 401(k)s.

This approach helps you avoid “wasting” tax efficiency where it doesn’t matter and reduces overall tax drag across your portfolio.

ETFs are well-suited for tax-loss harvesting, one of the few ways investors can actively manage taxes.

If an ETF declines in value, you can sell it to realize a loss, offset gains elsewhere and reinvest in a similar, but not identical, ETF to maintain market exposure. Just be mindful of wash sale rules when repurchasing. If you buy the same or a “substantially identical” investment within 30 days before or after the sale, the IRS can disallow the loss for tax purposes.

Holding investments for more than one year can reduce your tax rate on gains.

That simple shift from short-term to long-term can make a difference between being taxed at ordinary income rates versus lower capital gains rates.

Over time, that gap can add up, especially in taxable accounts where every sale has tax consequences.

Even tax-efficient ETFs occasionally distribute gains.

Before buying late in the year, check whether a distribution is scheduled. Buying just before a payout can create an unexpected tax bill, even when you haven’t yet benefited from the fund’s gains. This strategy can help you avoid paying taxes on gains you never saw in the first place.

Mutual funds vs. ETFs: How do these types of investment funds stack up?

Investing builds wealth over time, but no single investment does it all. Diversification helps balance risk and keep your strategy on track.

See how to build a diversified portfolio

ETFs tend to be more tax-efficient than mutual funds because of how they handle buying and selling behind the scenes. When investors move money in or out of an ETF, transactions usually are done “in kind,” meaning shares of the underlying investments are exchanged rather than sold for cash. That process helps the fund avoid realizing capital gains, so fewer taxable distributions get passed along to shareholders.

Mutual funds, on the other hand, often have to sell investments to meet redemptions or rebalance the portfolio. Those sales can trigger capital gains that are then distributed to investors, even if you didn’t sell anything yourself.

The result: with ETFs, you’re more likely to control when you pay taxes, instead of inheriting a tax bill from someone else’s decision.

The biggest difference between ETFs and mutual funds comes down to how shares are created and redeemed.

In a mutual fund, when investors want to exit, the fund may need to sell securities to raise cash. If those sales generate gains, the fund distributes them to all shareholders as of the record date, typically just before year-end, regardless of whether they sold their shares of the mutual fund or not.

ETFs work differently. Large institutional investors, known as authorized participants, don’t redeem ETF shares for cash. Instead, they exchange shares for a basket of underlying securities. This is called an in-kind redemption.

Because the fund isn’t selling those securities for cash, the transaction typically doesn’t trigger a taxable event inside the fund. That means fewer capital gains passed on to investors. The result is a structural advantage. In 2024, only about 5% of ETFs distributed capital gains, compared to 43% of mutual funds.

Another key factor is where most ETF trading actually happens.

When you buy or sell an ETF, you’re usually trading with another investor on an exchange, not the fund itself. That means your transaction doesn’t force the fund manager to buy or sell underlying securities.

This setup helps insulate long-term investors from the actions of others. In a mutual fund, one investor’s exit can create a tax bill for everyone. With ETFs, that risk is significantly reduced, as you’re far less likely to pay taxes because someone else decided to sell.

Many ETFs track indexes, which means they don’t trade frequently.

Lower turnover generally leads to fewer realized gains inside the fund—and fewer gains to distribute to investors. It’s a quiet advantage that reinforces the same pattern: less internal trading, fewer taxable events and more consistency in after-tax outcomes.

ETFs are often considered one of the most tax-efficient options available, but they’re not the only approach. Each investment type offers a different tradeoff between control, simplicity and tax outcomes.

Here’s how ETFs compare to other types of investments.

• Mutual funds are generally less tax-efficient due to more frequent capital gains distributions, though some funds do employ a low-turnover, tax-friendly approach.
• Individual stocks offer maximum control over when gains are realized but require more effort to manage and lack built-in diversification
• Index mutual funds are more efficient than actively managed funds, but still more likely to distribute gains than ETFs.
• Direct indexing: is highly tax-efficient with ongoing tax-loss harvesting, but it’s also more complex and typically requires higher investment minimums.

For most investors, ETFs strike a good balance of simplicity, diversification and tax efficiency.

ETFs are designed with tax-efficient advantages in mind. Their structure helps minimize capital gains distributions, giving you more control over when you pay taxes and offering a clear advantage over traditional mutual funds.

And if you're unsure how ETFs fit into your bigger picture, a Thrivent financial advisor can help you build a plan that aligns your investments with both your goals and your tax picture. Get connected with a financial advisor who meets your needs.