More than half of all American households own a mutual fund or an exchange-traded fund (ETF), according to a recent survey . Over the past several decades, ownership of these investment products has become common. In many ways, the two kinds of funds are very similar. Both combine money from many people to invest in a broad group of stocks, bonds, and other assets. This enables investors to spread risk across a portfolio of companies, reducing exposure to any single stock while increasing the chances of making a profit and growing savings.
However, there is a key difference between mutual funds and ETFs. Currently, the U.S. tax code treats the two investment products in very different ways, with the result that investors must pay significantly more taxes on mutual funds than on ETFs. In a new report, Brookings Institution scholar Elena Patel argues that this disparity is unfair, especially for middle- and lower-income investors, who are more likely to put their money into mutual funds rather than ETFs. She also examines strategies to adjust the tax code to level the playing field, making it more fair, straightforward, and efficient.
“Many investors don’t realize that this difference exists,” says Patel, who is co-director of the Brookings Tax Policy Center. “It’s created an uneven playing field for millions of Americans.” She says the current tax code penalizes mutual fund investors, collectively costing them billions of dollars a year in excess taxes. She collaborated on the report with Matthew C. Ringgenberg, a professor of finance at the University of Utah and an expert on mutual funds and ETFs.
The main difference in how these funds are taxed lies in what happens when shares in the fund are sold. When an investor withdraws money from a mutual fund, the fund manager may have to sell some of the underlying assets to generate cash to give to the investor. If the fund’s assets have increased in value since the investor first bought them, this sale triggers a capital gains tax not only for that investor, but for all investors—even those who haven’t sold their shares.
Patel and others argue that this is unfair, because it requires all investors to pay taxes, not only those who have sold their shares. The key issue, she says, is the timing. Both ETF and mutual fund investors will eventually have to pay taxes on their gains, but mutual fund investors must often pay earlier, often years earlier, which can significantly reduce their overall gains. The difference in timing enables ETF investments to outperform mutual fund investments—even when the two kinds of funds hold exactly the same stocks and bonds.
Millions of Americans have long relied on mutual funds as their primary vehicle for diversified investing, particularly for retirement. Ownership of ETFs didn’t become popular until the past two decades, but over that time their use has expanded significantly.
Millions of Americans now own ETFs, and many own both kinds of funds. The two kinds of funds often include the same stocks and bonds, which makes the difference in how they are taxed even more stark. This is even more true because ETF ownership rises sharply as income goes up. Mutual fund ownership, by contrast, is more evenly distributed across all income levels. As a result, the current tax structure for mutual funds and ETFs tends to deliver larger benefits to those with higher incomes.
Several recent legislative proposals have tried to reduce or eliminate this tax disparity. In 2021, Sen. Ron Wyden, D-Ore., introduced a proposal to bring ETF tax treatment in line with that of mutual funds. The proposal was released as a discussion draft but was never enacted. More recently, the bipartisan GROWTH Act has proposed moving in the opposite direction by essentially bringing mutual fund taxation much closer to the way ETFs are treated. Each approach has distinct implications for investors, for market efficiency, and for tax revenues. Some experts worry that taxing ETFs like mutual funds could exacerbate market volatility as well as market downturns. More broadly, eliminating the ETF exemption would mean that ETF shareholders would face the inequity of being taxed even if they don’t sell their shares.
The GROWTH Act would align the tax code so that capital gains are only taxed when individual investors sell their shares of either kind of investment fund. With this approach, funds would continue to pass through interest and dividend income, but an individual investor’s capital gains would continue to accrue until that investor exited their position.
This strategy would improve economic efficiency by allowing investor outcomes to reflect underlying risk and return, rather than the actions of other shareholders. Many European countries already use versions of this approach. One possible disadvantage of this approach, she notes, is that it will shift the timing of tax revenues. While total tax revenues over the lifetime of the investment could be higher due to higher compound returns inside the fund, this revenue would generally not be collected until the individual investor sells their shares. Furthermore, this approach has the potential to significantly reduce government tax revenues, because any profits would be exempted from capital gains taxes if the funds are held until the investor dies.
But overall, Patel says, this option could offer a clearer, more straightforward framework that advances equity, efficiency, and simplicity in the taxation of mutual funds and ETFs.
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