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Why Are ETFs (Sometimes) More Tax-Efficient Than Mutual Funds?

A reader writes in, asking:

“Could you provide an explanation of why ETFs are often said to be more tax efficient than mutual funds or index funds? I’ve read about it before but have never been able to follow.”

I’m happy to discuss this, but in order to understand the idea, we have to cover some background information first. Specifically, we have to discuss:

  • One basic concept about the tax treatment of funds, and
  • How shares of an ETF are created.

What Happens When a Fund Sells Something?

Whenever a fund (whether an ETF or traditional mutual fund) sells one of its holdings from the portfolio, if that holding is sold at a gain, shareholders of the fund have to pay tax on their share of that gain (if they hold the fund in a taxable brokerage account, that is).

How ETF Shares Are Created

When an investor buys shares of a traditional mutual fund, the transaction is a transaction between the investor and the mutual fund itself. The investor gives cash to the fund, and the fund creates new shares of the fund, which are given to the investor.

In contrast, when you or I buy shares of an ETF, we’re buying already-existing shares from some other shareholder who already owned those shares. So how do ETF shares get created in the first place?

The answer has to do with entities known as “authorized participants.” Authorized participants are generally super big financial entities (e.g., banks).

When a company that runs an ETF wants to create shares, it essentially does a swap with an authorized participant. It creates new shares of the ETF, and it gives those shares of the ETF to the authorized participant, in exchange for cash or a “basket” of securities (e.g., the 500 stocks in the S&P 500, if it’s an ETF that tracks the S&P 500). These swaps are usually done in very large dollar amounts (e.g., 50,000 shares of the ETF in exchange for the appropriate amount of other securities).

The ETF Tax Advantages

When an investor in a traditional mutual fund wants to sell his/her shares for cash, the transaction is again a transaction with the mutual fund itself. The fund needs to have cash on hand, so that it can pay that cash out to the shareholder redeeming the shares. And sometimes (depending on how many shares are being redeemed on any given day) raising that cash requires selling stuff. And as we discussed earlier, when a fund sells anything at a gain, shareholders in that fund have to pay tax on their share of that gain. In other words, when one shareholder sells his shares of the mutual fund, if the fund has to sell stuff at a gain in order to pay off that shareholder, that creates a tax cost that will be ultimately be paid by the remaining investors in the fund.

In contrast, if you or I want to sell shares of an ETF, that’s a transaction that happens on the secondary market. We aren’t transacting with the fund itself at all. We’re just selling our shares to somebody else who wants to buy them. And that means that the ETF doesn’t have to do anything — doesn’t have to sell anything, and no tax costs are incurred by remaining shareholders in the fund.

In addition, when an authorized participant wants to redeem shares of the ETF, the ETF basically does the share creation process (i.e., the swap described above), just in the opposite direction. This is known as a share redemption. In an ETF redemption, the ETF gives shares of investments to an authorized participant, and the authorized participant gives ETF shares back to the fund. And because this is an “in-kind” transaction, it’s not considered a taxable event. So the ETF is able to hand off those underlying investment shares without technically having sold them — no tax cost.

This is made even more tax-efficient by the fact that, when the ETF swaps out shares of any given company, it will naturally choose to give away the shares that have the lowest cost basis (i.e., keep the ones that have the highest cost basis, in case they have to be sold — thereby allowing any gains that have to be realized to be smaller gains).

So, in short, ETFs are often more tax-efficient than traditional mutual funds because they have a way of satisfying redemptions without having to actually sell anything and because they have a way of strategically unloading their shares of investments with the lowest cost basis (without generating a capital gain in the process).

Two Important Caveats

While the ETF structure does give it some tax advantages over a traditional mutual fund, there are two important caveats to keep in mind.

First caveat: the underlying portfolio and investment strategy of the fund still matters. It matters a lot. For instance:

  1. A fund (whether it’s an ETF or mutual fund) that follows a “total stock market” strategy is going to be much more tax-efficient than an actively managed stock fund that does a lot of buying and selling. Because, as discussed above, selling stuff at a gain results in tax costs to shareholders. So, higher portfolio turnover generally means worse tax-efficiency, and lower portfolio turnover generally means better tax-efficiency — regardless of whether the fund is an ETF or traditional mutual fund.
  2. A fund that pays a lot of fully-taxable ordinary income (e.g., a high-yield corporate bond fund) is simply not going to be very tax-efficient — and that’s true regardless of whether the fund is an ETF or traditional mutual fund.

Second caveat: this whole discussion largely does not apply to Vanguard ETFs as compared to Vanguard index funds. That’s because for many Vanguard funds, the ETF and index fund are literally the same fund. They’re just different share classes. So the share redemption process that ETFs can use (i.e., swapping out shares of holdings with low cost basis, to authorized participants) benefits the Vanguard index funds as well (as long as the index fund in question also has an ETF share class). In addition, the Vanguard patent on this “ETFs as a separate share class of an existing fund” idea recently expired (in May 2023). So it would not be at all surprising if other fund companies eventually implemented the same concept. (And many companies are already actively in the process of doing so.)

Investing Blog Roundup: IRS Direct File to Be Made Permanent, Expanded

At the end of April, the IRS announced that their pilot program Direct File went very well by any measure. Now, they’ve announced that the program will be made permanent, and access will be expanded both in terms of available states and tax situations covered.

Without exaggeration, I think this is the best development we’ve seen in the tax world during my entire time in the industry.

Other Recommended Reading

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What Roth Conversions Are Likely (And Unlikely) To Achieve

The topic that I help clients with most often is retirement tax planning. And my approach to that work includes modeling different tax strategies in financial planning software.

When I do that, what I find is that a plan for tax-efficient spending (i.e., which dollars to spend each year in retirement) often has a significant impact on retirement safety. For example, it often has the result of:

  • Reducing the projected probability of portfolio depletion by several percentage points (e.g., from 20% to 14%), while also
  • Pushing back the date at which those depletion scenarios do occur (e.g., so that in the “unlucky” scenarios, the household now runs out of savings in their mid 90s instead of late 80s).

But once you have a tax-efficient spending plan in place, a Roth conversion plan does not usually result in any meaningful improvement to retirement safety. That is, conversions don’t typically improve either of those metrics above by a meaningful amount.

And that has been my experience with a broad range of clients — ranging from super financially secure to more borderline, with varying ages upon retirement, and with a wide variety of portfolio sizes and compositions. And that has been the case using a broad variety of assumptions (e.g. varying assumed lifespans, average investment returns, etc.).

Roth conversions simply do not tend to increase retirement safety.


This is a simplification, but I often think of Roth conversions as a tool for solving/alleviating two “problems.” (For more on these topics, please see this article: The 4 Effects of Roth Conversions.)

  1. Required minimum distributions (RMDs) from tax-deferred accounts (both during your lifetime and after your death).
  2. The ongoing tax drag that occurs in taxable accounts (i.e., by letting you use taxable dollars to pay the tax on a conversion — thereby effectively using your less-tax-efficient taxable dollars to buy very tax-efficient Roth space).

But neither RMDs nor tax drag in taxable accounts is on the list of “stuff that’s likely to cause portfolio depletion in retirement.”

RMDs simply do not cause people to go broke. (In fact, RMDs are often recommended as a strategy for spending from a portfolio.)

And in unlucky retirement scenarios (e.g., poor investment returns early in retirement or a major spending shock early in retirement), the problem of tax drag in the taxable account typically solves itself, because the taxable account usually gets spent down pretty quickly in those scenarios anyway.

So Why Bother with Roth Conversions?

Given the above, you might ask why a person would bother with Roth conversions. The answer is that, in cases in which Roth conversions are suitable (which, for many but not all households, is in the years after retiring but before collecting Social Security and before RMDs kick in), they provide a significant increase in the the after-tax bequest that is likely to be left to heirs. (Again, please see this article for a discussion of the mechanics.)

In other words, a well-crafted Roth conversion plan typically:

  1. Does not make the unlucky outcomes significantly better or worse and
  2. Makes the lucky outcomes significantly better.

When I say “a well-crafted Roth conversion plan,” what I mean is a plan that carefully considers whether conversions should be done each year, and if so, to what threshold. Roth conversions are not suitable for everybody. For instance, households with large charitable intent are much less likely to benefit from conversions, because they can use qualified charitable distributions to satisfy RMDs and because the after-death tax rate on their tax-deferred accounts will be 0% to the extent the balances are left to charity.

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Investing Blog Roundup: 2024 Bogleheads Conference Registration Open

Quick housekeeping note: I’m on vacation for the next couple of weeks. The regular posting schedule will resume in June.

I’m excited to announce that registration for the 2024 Bogleheads Conference is now open!

In addition to all of the regulars, as well as many first time speakers I’m excited to hear from, I think it’s especially noteworthy that the lineup includes:

  • William Bengen (who did the original study that resulted in the “4% rule”),
  • Jonathan Guyton (known for his research on the “guardrails” approach to retirement spending), and
  • Karsten Jeske (who has written no fewer than 60 articles on the topic of spending from a portfolio).

I can’t wait to see a discussion between them about retirement spending.

You can find more information (and register) here:

Other Recommended Reading

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Avoiding Miscommunications with the SSA

Over the ~13 years that I’ve been dealing with Social Security frequently, I’ve encountered hundreds of cases of critical miscommunications between the SSA and somebody contacting the SSA to apply for benefits or ask questions about their benefits. When I say “critical miscommunication,” I’m talking about cases in which the result is the person making a poor decision based on the resulting misunderstanding, cases in which the person completely misses out on benefits they could have received, or cases in which the result is a tremendous amount of administrative hassle in order to get the situation fixed.

There are, broadly speaking, two things you can do when interacting with the SSA to minimize the likelihood of such miscommunications:

  1. When applying for benefits, apply online (except for survivor benefits, for which you can’t file online).
  2. Be very careful about terminology (both yours and theirs).

Apply Online

In my entire time dealing with Social Security issues, I’ve never had any direct personal experience of an online application going wrong. I’ve encountered one story on the Bogleheads forum of such. In contrast, I don’t know how many people I’ve interacted with over the years who had a phone or in-person application not go according to plan. At least a hundred, I’m sure.

And really this shouldn’t be that surprising. Humans make mistakes. Computers, less so.

So, when applying for retirement or spousal benefits, please, apply online. And help your loved ones apply online.

Unfortunately, you cannot apply for survivor benefits online. You’ll have to make an appointment to apply over the phone or in person.

Exercise Caution with Terminology

Any time you’re dealing with anybody at the SSA, it’s important to be very careful with the terminology you use and pay careful attention to the terminology they are using.

I’ve encountered a lot of situations that followed a pattern like this:

  • Bob has a question about Social Security. Let’s call it Question A.
  • Bob visits his local SSA office.
  • Bob meets with an SSA employee and asks the employee his question. Unfortunately, Bob uses the wrong terminology and accidentally asks Question B instead, without realizing the distinction.
  • The SSA employee answers Question B.
  • Now Bob thinks that the answer to Question B is the answer to Question A.


With something as complex as Social Security, there are infinite possible miscommunications and misunderstandings. But there are a handful that come up quite a lot.

Eligible vs. Entitled

You are eligible for a given type of benefit once you meet the requirements for that type of benefit but you have not yet filed for it. You are entitled once you are eligible for the benefit and have filed for it.

Example miscommunication: Bob asks, “Once I’m 62 and entitled to a retirement benefit, can I put off filing for my spousal benefit, or do I have to file for that immediately?” In Bob’s mind, in the example scenario he had not yet filed for his retirement benefit. He should have said eligible rather than entitled. If the SSA employee simply answers the question as stated (rather than trying to suss out what Bob might have meant to say), they will answer the question assuming that, in the scenario given, Bob has already filed for his retirement benefit, which can change the answer.

Monthly Benefit vs. Primary Insurance Amount (PIA)

Another common source of miscommunication is the distinction between a monthly benefit amount and a primary insurance amount. Your PIA is the monthly retirement benefit you would receive if you file for it exactly at your full retirement age. Your actual monthly benefit could be more or less than your PIA, depending on the age at which you file as well as various other factors (e.g., the earnings test).

Example miscommunication: Julie asks, “After I file for my retirement benefit at age 70 and Jimmy files for his benefit as my spouse, what will his total monthly benefit be?” The SSA employee responds, “Half of your primary insurance amount.” If Julie doesn’t recognize the distinction between her monthly benefit and her PIA, she may think that Jimmy is going to get half of her monthly benefit, when in reality he’ll receive less than that.

Spousal Benefits vs. Survivor Benefits

Spousal benefits (a.k.a. husband/wife benefits) are only applicable while both spouses are still living. Survivor benefits (a.k.a. surviving spouse benefits or widow/widower benefits) become relevant after one spouse’s death.

Example miscommunication: Samantha is the higher earner in her marriage, and she’s trying to understand how her filing date could affect the amount her spouse could receive as a survivor benefit later, if applicable. She asks, “If I wait until age 70, does that increase the amount that Neil can receive as my spouse?” The SSA employee responds, “No, his benefit as your spouse does not depend on the age at which you file for your retirement benefit.” That’s true. But his benefit as her survivor (if applicable) would depend on the age at which she filed for her retirement benefit.

You Never “Switch from” a Retirement Benefit to a Spousal or Survivor Benefit

Another common source of miscommunications is the misconception that you “switch to” a spousal or survivor benefit after having received your own retirement benefit earlier. That never happens. You keep receiving your own retirement benefit, and you receive a spousal or survivor benefit in addition to the retirement benefit.

Example miscommunication: Frank’s PIA is $2,000. His spouse Betty’s PIA is $600. Betty is several years older than Frank. She files for her own retirement benefit at her full retirement age, and she asks what her spousal benefit will be after Frank files for his retirement benefit. The SSA employee replies, correctly, that it will be $400. Frank and Betty might misunderstand this to mean that Betty will only get her own $600 retirement benefit (i.e., the greater of the two amounts) or that her monthly benefit will even decrease to $400. In reality, she will get her $600 retirement benefit, plus her $400 spousal benefit, for a total monthly benefit of $1,000 (i.e., 50% of Frank’s PIA).

Do Not Use the Verb “Retire”

For some reason, the SSA often refers to filing for a retirement benefit as “retiring.” This is not a part of SSA technical jargon, but it is something that appears in various publications of theirs, and it’s the way that many SSA employees speak. (In other words, this is a case of the SSA being lazy/imprecise with their own wording, which frankly I find inexcusable given how complicated this stuff is even when we communicate with perfect precision.)

If you are providing a hypothetical scenario and you mean to say that you’ll stop work at, for example, age 64, use those words: “stop work at age 64.” If you say “retire at age 64” the SSA employee might think you mean “apply for retirement benefits at age 64.”

Avoiding Miscommunications and Mistakes

So, again, apply online (when possible), be careful with your wording, and pay close attention to the exact wording that the SSA employee is using.

I’ll also point out that, while this exercise of caution does become more difficult as more complicating factors come up (e.g., benefit calculations when WEP/GPO are involved), it also becomes even more critical. So take your time.

I think it’s often a good idea to put your question on paper. That way you can plan it out thoroughly beforehand, you won’t forget to state anything important, and (if it’s an in-person appointment) the SSA employee you meet with can read it and reread it as necessary.

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  • How Social Security benefits are taxed and how that affects tax planning,
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Investing Blog Roundup: IRS Direct File Pilot Program Results

For as long as I’ve been in the tax field (and probably longer, though I wasn’t aware of it), people have been saying that the IRS should create some easy, free way for people to file their tax returns online. And with the agency’s improved funding from the Inflation Reduction Act, the IRS has finally been working on doing exactly that.

This year the IRS ran a “Direct File” pilot program, available in just twelve states and available only to people with straightforward tax situations. Obviously that’s just a start toward what’s needed, but everything I’ve heard indicates that the program went very well. Of people who used the program and completed the survey afterward, 90% indicated that their experience with Direct File was “Excellent” or “Above Average.” And 86% said that their experience with Direct File increased their trust in the IRS.

Other Recommended Reading

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