Are ETFs tax-efficient?

Are ETFs, or "exchange-traded funds," tax-efficient?

When it comes to distributing capital gains, yes!

Although ETFs trade like stocks, they can distribute capital gains like mutual funds. So you can have capital gains in some years, even if you don't sell any shares. That's because the ETF manager may need to sell some of the ETF's underlying holdings for a variety of reasons. At the end of the year, any gains from those sales (minus any losses) are then paid out to all of the ETF's shareholders.

But here's why ETFs can be just as tax-friendly as index funds—and way more tax-friendly than actively managed funds.

Most ETFs try to track an index, like the S&P 500. They only add and remove stocks when the index does. Big moves—like when a company is completely removed from an index—happen very rarely. So you'll usually have few, if any, capital gains distributions to report at tax time.

On the other hand, actively managed funds try to beat an index. Their managers may buy and sell investments more often. The more they trade, the more likely they'll accumulate capital gains―and the higher your potential tax liability once those gains are tallied at the end of the year.

Keep in mind that, whether your investments pay capital gains or not, you have a lot of control over how much you'll owe in taxes. No matter if you invest in ETFs, mutual funds, or individual stocks or bonds, you could be better off investing for the long term. That's because the more you trade, the higher your capital gains could be. Capital gains aren't necessarily bad; they mean you've made money! But unless you trade in a tax-deferred account, like an IRA, you'll pay taxes on the gains you've "realized" come April.

The actual rate you'll pay depends on 2 things—how high your tax rate is and how long you've held your shares. If you sell your shares in the first year, your gains will be taxed the same as your regular income. But if you keep your shares longer than a year, you'll pay a much lower rate when you sell.

The key point to remember is that, for the majority of ETFs, capital gains distributions are few and far between—yet another reason you should consider them as part of your long-term, buy-and-hold strategy.

You can select from more than 75 tax-efficient Vanguard ETFs® that cover nearly all areas of the U.S. and international stock and bond markets.

(Vanguard ETF® ticker symbols: VTI, VOO, VWO, VEA, VTV, BND, VUG, VNQ, VIG, VEU, BSV, VO, VB, VYM, VCSH, VGK, VCIT, VGT, BIV, VBR, VV, VXUS, VT, BNDX, VOE, VFH, VHT, VBK, VNQI, VXF, VPL, VOT, VSS, VMBS, VTIP, VDE, VDC, VIS, MGK, VCR, VPU, VAW, BLV, VCLT, VTEB, VOOG, MGV, VGSH, VGIT, VONG, MGC, VONV, VTWO, VOX, VWOB, VIGI, VOOV, IVOO, VYMI, VONE, IVOG, VIOO, VGLT, IVOV, EDV, VTHR, VIOG, VIOV, VTWG, VTWV, VTC)

To learn more, view our full list of ETFs.

For more information about Vanguard ETFs, visit vanguard.com/etfprospectus to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider carefully before investing.

You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free) or through another broker (which may charge commissions). See the Vanguard Brokerage Services commission and fee schedules at vanguard.com/commissions for limits. Vanguard ETF Shares are not redeemable directly with the issuing fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.

All investing is subject to risk, including the possible loss of the money you invest.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

Although our investment professionals are qualified to provide information about Vanguard funds and services, they cannot provide tax advice. If your tax situation is complex or if you are uncertain of the interpretation of a specific tax rule, we recommend that you seek advice from a qualified tax professional.

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