5 Tax-Efficient ETFs to Diversify Your Portfolio
Exchange-traded funds are generally less onerous tax-wise than mutual funds, but these tax-efficient ETFs stand apart.
When you make money in a taxable account, Uncle Sam will eventually claim a portion of it. The rate you pay depends on how that return is classified. Capital gains, for example, are divided into short term and long term.
Dividends are also split into qualified and non-qualified. The highest tax burden typically falls on ordinary income, which includes interest payments from bonds and distributions from real estate investment trusts (REITs)
If you want to keep more money compounding in your portfolio, it may serve you better to focus less on chasing the highest returns and more on what the government takes off the top.
Article continues belowFrom just $107.88 $24.99 for Kiplinger Personal Finance
Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Over time, tax drag can quietly erode performance just as much as a bad investment decision.
While accounts such as Roth IRAs or workplace 401(k) plans offer tax advantages, contribution limits apply and eligibility can be restricted. A standard brokerage account is far more flexible when it comes to contributions and withdrawals, but taxes apply in full. That makes fund selection especially important.
Below, we break down how tax efficiency works for exchange-traded funds (ETFs) compared with mutual funds. We also highlight five ETFs that stand out for their ability to minimize tax drag in 2026.
Why ETFs are more tax efficient than mutual funds
Before 1993, when the first U.S.-listed ETF debuted, mutual fund investors routinely faced a frustrating problem at year end: large capital gains distributions.
A mutual fund is an open-ended vehicle. Inside the portfolio, every time the manager buys or sells a security, that transaction can become a taxable event. If a security is sold above its cost basis, the gain is realized.
There are two common ways this happens. The first is through active management. In an attempt to outperform a benchmark, managers may trade frequently. High portfolio turnover increases the odds that appreciated positions are sold, locking in realized gains.
The second is investor redemptions. If a once high-flying mutual fund hits a rough patch and investors rush to pull money out, the fund must raise cash. If there isn't enough cash on hand, the manager may be forced to sell appreciated securities to meet withdrawals. That sale realizes gains.
Here's the catch: Even if you personally did not sell a single share of the mutual fund, you can still receive a capital gains distribution at year end.
This is because mutual funds do not pay taxes at the fund level as long as they distribute realized gains and income to shareholders. You then owe taxes at your own rate.
That distribution reduces the fund's net asset value, and you pay the tax bill. If you reinvest the proceeds, you're compounding from a slightly diminished base. Over time, that tax drag can meaningfully reduce after-tax returns.
ETFs largely avoid this problem because of their in-kind creation and redemption mechanism. When new shares are created, an authorized participant delivers a basket of securities to the ETF issuer in exchange for ETF shares. When shares are redeemed, the process works in reverse. The ETF hands out a basket of securities instead of selling them for cash.
Because securities are transferred in kind rather than sold on the open market, the ETF typically does not realize capital gains. This structure acts as a built-in tax management tool and is one of the main reasons ETFs are generally more tax efficient than mutual funds.
That said, not all ETFs are equally tax efficient. While capital gains distributions are rare, most ETFs still distribute investment income.
For example, dividend ETFs collect payments from the stocks they hold and pass them through to shareholders. Those dividends may be qualified, often from U.S. corporations, or non-qualified, more common with global diversification.
Bond ETFs distribute interest income, which is usually taxed as ordinary income. Treasury bond ETFs are generally exempt from state and local taxes. Municipal bond ETFs may be exempt from federal income tax and sometimes state tax as well. Corporate bond ETFs, however, are taxed at federal and state levels.
Other ETF categories can be less tax friendly or complex. REIT ETFs often pass through income that isn't qualified and is taxed at higher rates. Some options-based strategies may distribute large amounts of return of capital. While not immediately taxable, it reduces your adjusted cost basis and can result in a larger capital gains bill when you eventually sell.
The bottom line is that while ETFs are typically more tax efficient than mutual funds, there is still meaningful variation within the ETF universe. Understanding what an ETF holds, how it generates income and how those distributions are classified is essential.
Investors can review this information on their year-end Form 1099-DIV, which details dividends and capital gains distributions. Careful selection can help minimize tax drag and keep more of your returns compounding over time.
How we selected the most tax-efficient ETFs
If we had ranked funds purely by after-tax returns, the list would have skewed almost entirely toward municipal bond ETFs.
While municipal funds can be highly tax efficient, that approach would not be very helpful for investors trying to build a well-diversified portfolio across multiple asset classes.
Instead, we structured our selection around five distinct categories: equities; bonds; commodities; cryptocurrency; and cash-like. The goal was to identify one ETF within each asset class that historically demonstrated minimal tax drag.
In some cases, that meant a fund with a very low or non-existent yield. In others, it meant a fund whose distributions leaned toward more tax-friendly sources, such as qualified dividends or return of capital, rather than ordinary income.
We also favored broadly diversified funds within each category. Concentrated strategies, even if tax efficient, can introduce uncompensated risk tied to a single sector, country or security. By emphasizing diversified exposure, we aimed to ensure each ETF could realistically function as a core building block rather than a narrow tactical trade.
After narrowing the field within each category, we applied criteria to ensure durability and usability. Each fund selected had at least $1 billion in assets under management to reduce closure risk and support economies of scale. We also capped expense ratios at 0.2%.
The result is a group of ETFs that not only aim to reduce tax drag, but also meet structural standards for liquidity and long-term viability.
Vanguard Growth ETF
- Inception date: January 26, 2004
- Assets under management: $203.5 billion
- Expense ratio: 0.03%
- 30-day SEC yield: 0.38%
While most equity ETFs avoid the large year-end capital gains distributions that historically affected mutual funds, investors can still face taxes from regular dividend payouts. Those dividends are taxable in a brokerage account.
One way to improve tax efficiency is to focus on funds with minimal yields or dividends that are largely qualified. Growth ETFs tend to hold companies that reinvest excess cash back into their businesses rather than distribute it to shareholders. As a result, yields are typically low.
The Vanguard Growth ETF (VUG) tracks the CRSP U.S. Large Cap Growth Index. The portfolio currently reflects an average earnings growth rate of 31.4% and a return on equity of 37.1%. In practical terms, these are firms prioritizing expansion, innovation and market share over dividend payouts.
The result is a modest yield, and much of that income is composed of qualified dividends, which are taxed at more favorable rates.
The trade-off is concentration. The fund is relatively top-heavy and heavily weighted toward tech stocks, which accounts for 65.7% of the portfolio
Learn more about VUG at the Vanguard provider site.
iShares National Muni Bond ETF
- Inception date: September 7, 2007
- Assets under management: $42.8 billion
- Expense ratio: 0.05%
- 30-day SEC yield: 3.15%
Investors looking for a tax-efficient way to lower overall portfolio risk may consider a municipal bond ETF such as the iShares National Muni Bond ETF (MUB), which tracks the ICE AMT-Free U.S. National Municipal Index and holds a diversified portfolio of more than 6,100 municipal bonds issued by state and local governments.
The majority of the portfolio is rated AA, with most of the remainder in AAA and single-A categories. That credit profile places it toward the higher-quality end of the fixed income spectrum, reducing default risk relative to lower-rated bonds.
At first glance, the 30-day SEC yield may appear lower than what is available from many taxable bond funds.
However, the key distinction is that MUB’s income is exempt from federal income tax and also exempt from the federal alternative minimum tax (AMT). For investors in higher tax brackets, this materially changes the comparison.
The more appropriate measure is the tax-equivalent yield. This figure estimates the yield a taxable bond would need to generate after taxes in order to match the tax-free income provided by a municipal bond fund.
According to iShares, MUB's tax-equivalent 30-day SEC yield is approximately 5.32%.
Learn more about MUB at the iShares provider site.
SPDR Gold MiniShares Trust
- Inception date: June 25, 2018
- Assets under management: $32.0 billion
- Expense ratio: 0.10%
- 30-day SEC yield: 0.00%
Some commodity ETFs that hold futures contracts can generate sizable year-end capital gains distributions. Futures positions must be rolled as contracts approach expiration. If those contracts are sold at a gain, the fund, as a pass-through vehicle, must distribute it to shareholders.
The SPDR Gold MiniShares Trust (GLDM) avoids that issue because it does not use futures at all. Instead, GLDM is backed by physical gold bullion held in custody with JPMorgan Chase Bank. As a spot gold ETF, its share price is designed to track the market price of gold during trading hours.
Gold itself is a non-cash-generating asset. It doesn't pay interest or dividends. As a result, GLDM carries no yield and typically doesn't distribute income to shareholders. That makes it structurally tax-efficient in a taxable account while you hold it.
However, taxes still apply when you sell. Physical gold and gold-backed ETFs are treated as collectibles under IRS rules. Long-term capital gains on collectibles don't receive the standard preferential rates applied to stocks and most ETFs. Instead, they're subject to a maximum federal tax rate of 28%.
Learn more about GLDM at the State Street provider site.
Grayscale Bitcoin Mini Trust ETF
- Inception date: July 31, 2024
- Assets under management: $3.4 billion
- Expense ratio: 0.15%
- 30-day SEC yield: 0.00%
Spot bitcoin ETFs share a similar structural tax advantage to physical gold funds. Bitcoin itself doesn't generate cash flow. There are no dividends and no interest payments.
As a result, the Grayscale Bitcoin Mini Trust ETF (BTC) has no yield and doesn't make regular income distributions. For taxable investors, that means there's generally no tax bill while you continue to hold the ETF.
BTC is notable because it was launched through a spin-off from Grayscale's older and much larger spot bitcoin ETF, with approximately 10% of the assets carved out into this lower-cost vehicle.
The original fund charged a 1.5% expense ratio. BTC's fee is one-tenth of that, making it far more competitive.
Unlike gold, bitcoin is not treated as a collectible under IRS rules. When you sell shares of a spot Bitcoin ETF at a gain, taxation depends on your holding period. Short-term gains are taxed at ordinary income rates, while long-term gains qualify for standard long-term capital gains rates, which are typically lower.
Learn more about BTC at the Grayscale provider site.
Alpha Architect 1–3 Month Box ETF
- Inception date: December 27, 2022
- Assets under management: $9.8 billion
- Expense ratio: 0.1949%
- 30-day SEC yield: 0.00%
If your goal is to keep cash relatively safe while still earning a nominal return, the traditional solution has been a money market fund.
The drawback is that the income those funds distribute is generally taxable each year and may not be especially efficient depending on whether the holdings are Treasury bills, repurchase agreements, or corporate paper.
Municipal money market funds can improve tax treatment, but they are not the only option anymore.
The Alpha Architect 1-3 Month Box ETF (BOXX) takes a different approach. Instead of owning Treasury bills directly, BOXX seeks to replicate their total return through a multi-leg options strategy known as a "box spread."
This combines long and short call options and put options at different strike prices to create a payoff that closely resembles a fixed-income instrument. Institutions have long used variants of this structure to borrow at low rates.
Because BOXX relies on options rather than holding interest-paying securities, it aims to avoid regular taxable income distributions.
The more relevant metric for this fund is its average yield to options expiry, which represents the anticipated weighted average return from the current option positions held in the portfolio. That figure is currently around 3.91%, broadly in line with prevailing short-term interest rates.
It's important to note that while BOXX's objective is to limit taxable distributions and it has largely done so, the fund has made them sporadically in the past. Avoiding income is a goal of the structure, but it isn't guaranteed.
Learn more about BOXX at the Alpha Architect ETF website.
Related content
