This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
ETFs (exchange-traded funds) are a popular investment vehicle for taxable brokerage accounts, because they are generally more tax-efficient than mutual funds. The ETF structure allows the investor to defer the capital gains tax until the ETF is sold, while a mutual fund passes the capital gains on to the investors every year.
The role of ETFs in a taxable account depends on three factors: the dividend policy (distributing or accumulating), the turnover (low or high), and the holding period (short or long). An ETF that is well suited to a taxable account for one investor may be less suited for another investor, because the tax treatment depends on the investor's jurisdiction and the investor's tax rate.
The tax efficiency of ETFs
The tax efficiency of ETFs comes from the creation and redemption mechanism. When an ETF provider creates new ETF shares, the provider exchanges a basket of the underlying stocks for ETF shares. When an investor redeems ETF shares, the provider exchanges the ETF shares for the basket of underlying stocks. The mechanism allows the ETF to pass the in-kind creation and redemption to the market makers, and the in-kind transfer is not a taxable event for the ETF or for the investor.
A mutual fund does not have the creation and redemption mechanism. When a mutual fund sells a stock (to rebalance the portfolio or to meet redemptions), the fund realises a capital gain, and the capital gain is passed on to the fund's shareholders. The shareholder pays the capital gains tax on the fund's trading, even if the shareholder has not made any trades.
The difference is most significant for a high-turnover fund. A high-turnover ETF (a sector ETF that rebalances frequently) still has some tax efficiency from the creation and redemption mechanism. A high-turnover mutual fund has zero tax efficiency, because the fund's trades are passed on to the investor.
The dividend factor
The dividend factor is the most important factor for the ETF's role in a taxable account. An ETF that holds dividend-paying stocks (a dividend growth ETF, an income ETF, a blue-chip ETF) distributes the dividends to the ETF's investors, and the investor pays tax on the dividends as ordinary income or as qualified dividends.
An ETF that holds low-dividend stocks (a growth ETF, an AI ETF, an emerging markets ETF) distributes fewer dividends, and the investor defers more of the return to the capital appreciation. The capital appreciation is taxed at the capital gains rate when the ETF is sold, and the capital gains rate is usually lower than the income tax rate on dividends.
The investor who is in a high tax bracket should prefer low-dividend ETFs in the taxable account and high-dividend ETFs in the tax-sheltered account (an IRA in the US, an ISA in the UK, a pension fund). The investor who is in a low tax bracket or a zero tax bracket can hold any ETF in the taxable account.
The turnover factor
The turnover factor determines the amount of the capital gains that the ETF realises internally. A low-turnover ETF (a total market ETF, a buy-and-hold ETF) has minimal internal turnover, and the ETF's capital gains are minimal. A high-turnover ETF (a sector ETF, a thematic ETF, a managed ETF) has higher internal turnover, and the ETF may realise capital gains that are passed on to the investor.
The investor should check the ETF's turnover ratio and the ETF's capital gains distribution history. An ETF with a turnover ratio below 10% is a low-turnover ETF that is well suited to a taxable account. An ETF with a turnover ratio above 50% is a high-turnover ETF that may be better suited to a tax-sheltered account.
The holding period factor
The investor's holding period determines the tax rate on the ETF's capital gains. A short-term hold (less than one year in most jurisdictions) is taxed at the investor's marginal income tax rate. A long-term hold (more than one year) is taxed at the lower capital gains rate.
The investor who holds an ETF for the long term gets the benefit of the lower capital gains rate and the deferral of the tax until the ETF is sold. The investor who trades ETFs frequently pays the higher short-term capital gains rate, and the compounding of the tax drag reduces the net return.
Common questions about ETFs in taxable accounts
Are accumulating ETFs better for taxable accounts? Accumulating ETFs (where the dividends are reinvested internally) defer the dividend tax until the ETF is sold. Distributing ETFs pass the dividends to the investor each year. The accumulating ETF is better for a taxable account in most jurisdictions.
Do all brokers offer the same ETF selection? No. The ETF selection varies by broker and by jurisdiction. A broker in the US offers US-listed ETFs (VOO, SPY, QQQ). A broker in the EU offers UCITS ETFs (IWDA, VWCE, CSPX). The trader should check the broker's ETF availability.
Can I hold a US ETF in a non-US account? Some brokers outside the US offer US-listed ETFs, and some do not. The availability depends on the broker's regulatory status and the ETF's registration in the trader's jurisdiction.
Related resources
Where to start
If you are evaluating ETFs for a taxable brokerage account, the most useful first step is to compare the dividend policy, the turnover ratio, the capital gains distribution history, and the expense ratio. Our broker comparison lists the ETFs available at each broker and the fee schedule, which together tell you what the role looks like before you buy.