You did everything right last year — held your fund through a rough stretch, stayed disciplined, and never sold a single share of it. Your mutual fund still handed you a tax bill at the end of the year, even though your account balance dropped significantly overall.

That tax hit did not come from anything you did wrong, and it did not come from poor judgment or bad market timing on your part. It came from a structural flaw baked into the mutual fund wrapper itself, one that exchange-traded funds have quietly solved for years now.

A new Morningstar analysis lays out why ETFs dominate mutual funds on taxes, and the gap is growing wider by the year.

Two-thirds of mutual funds distributed capital gains during the 2022 crash

The core finding from Morningstar is alarming for anyone holding mutual funds in a taxable brokerage account outside of retirement shelters.

In 2022, the S&P 500 fell more than 18%, yet roughly two-thirds of U.S. equity mutual funds still distributed capital gains to shareholders. Those distributions averaged about 7% of the fund’s net asset value, according to Morningstar data cited in the latest report by Sheryl Rowling.

You read that correctly: Your fund lost money, but the IRS still expected a check from you because of gains realized inside the fund itself.

The collective action flaw that punishes loyal mutual fund investors

Mutual funds carry an inherent structural weakness that Morningstar calls a collective action flaw, and it directly affects your annual tax bill as an investor.

When other investors in your mutual fund sell their shares, the fund manager must liquidate holdings to raise cash and meet those redemption requests.

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If those sold holdings have appreciated over time, the fund realizes capital gains that get passed to every remaining shareholder, including you personally. You did not trigger the sale, you did not benefit from it directly, but you still owe taxes on the gains that someone else’s exit forced the fund to realize. 

This problem gets worse during market downturns because panicked investors redeem heavily, forcing managers to sell appreciated positions at the worst possible time for you.

How the ETF structure shields you from other investors’ tax consequences

ETFs solve this problem through a mechanism called in-kind creation and redemption, which keeps taxable events away from you as an individual shareholder. Instead of selling stocks for cash when investors redeem shares, ETF managers exchange baskets of underlying securities with authorized participants, which are large institutional traders.

This process allows the ETF manager to remove low-cost-basis shares from the portfolio without triggering a taxable event for the remaining shareholders in the fund. Section 852(b)(6) of the Internal Revenue Code exempts these in-kind distributions from capital gains tax, according to research published in The Review of Financial Studies.

Phil McInnis, chief investment strategist at Avantis Investors, explained the advantage to Morningstar in direct terms that any investor can understand clearly. McInnis said ETFs put tax planning control back in the hands of the advisor and client, rather than leaving it to fellow shareholders’ unpredictable behavior.

The data gap between mutual funds and ETFs keeps getting wider every year

The numbers paint a stark picture for anyone still holding mutual funds in a standard taxable brokerage account outside of retirement plan protections today.

Capital gains distribution rates by year:

  • 2022: The S&P 500 fell over 18%, yet roughly 66% of U.S. equity mutual funds paid capital gains distributions, per Morningstar data.
  • 2023: About 34% of mutual funds distributed capital gains versus just 4% of active ETFs, Morningstar research analyst Stephen Welch reported.
  • 2024: More than 80% of U.S. equity mutual funds distributed capital gains compared with only 5% of ETFs, according to American Century Investments analysis using Morningstar data.
  • 2025: Approximately 72% of U.S. equity mutual funds issued capital gains distributions with average payouts between 7% and 10% of NAV, Morningstar reports.

Bryan Armour, Morningstar’s director of ETF and passive strategies research, confirmed the pattern in a November 2025 analysis covering the full U.S. fund landscape. Armour found that just 7% of U.S. equity ETFs had capital gains distributions above zero in 2024, compared with 78% of mutual fund counterparts.

A $100,000 portfolio shows you the real cost of choosing the wrong wrapper

The tax drag difference between mutual funds and ETFs is not just a theoretical debate reserved for financial advisors and academic research papers today.

American Century Investments ran a comparison using Morningstar data over the 10-year period ending Dec. 31, 2024, and the results are hard to dismiss or ignore.

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More Personal Finance: For U.S. large-cap equity mutual funds, taxes consumed an average of 1.9% of returns annually over that decade, reducing long-term compounding significantly over time. Equity ETFs in the same category lost only 0.7% of returns to taxes annually, creating a meaningful gap that widened with each passing compounding year.

A $100,000 initial investment in the ETF portfolio ended the 10-year period with nearly $30,000 more than the equivalent mutual fund portfolio, per American Century data.

A peer-reviewed study published in The Review of Financial Studies estimated ETF tax efficiency boosted long-term investor returns by 1.05% per year versus mutual funds.

Investors ignoring ETF advantages risk paying unnecessary taxes, diminishing portfolio growth, and losing compounding benefits.

Practical steps you should take to reduce your mutual fund tax exposure

tsyhun/Shutterstock If you hold mutual funds in a taxable brokerage account, you have several options to reduce unnecessary tax drag without blowing up your investment plan entirely.

  • Check your account type first. If your mutual funds sit inside a 401(k), IRA, or Roth IRA, capital gains distributions do not trigger current-year taxes for you.
  • Prioritize ETFs for new taxable money. When adding fresh cash to a taxable brokerage account, choose a broad-market ETF such as VOO, VTI, or IVV for better tax efficiency.
  • Review your cost basis before selling. Selling a mutual fund to switch into an ETF may trigger a capital gain itself, so compare your basis to current net asset value first.
  • Use tax-loss harvesting strategically. If you hold positions with unrealized losses elsewhere, realize those losses to offset any capital gains distributions you received from mutual funds this year.
  • Redirect your distributions. Morningstar’s Christine Benz recommends unchecking the reinvestment box so distributions go to cash, which you can then deploy into tax-efficient ETFs going forward.

Not every ETF is tax-efficient, and not every mutual fund is a tax disaster

Steps to consider: Before you rush to dump every mutual fund you own, you should understand that the tax efficiency advantage does not apply equally across all fund types or categories. Bond ETFs, for example, do not benefit from the in-kind redemption mechanism as strongly as equity ETFs because bond income is taxed as ordinary income regardless of structure.

Commodity ETFs and futures-based products carry their own complex tax rules, including the 60/40 rule that treats gains differently depending on holding period and structure, Charles Schwab notes. 

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On the mutual fund side, Vanguard’s tax-managed funds and broad index funds have historically delivered tax efficiency on par with, or better than, comparable ETFs overall. 

Vanguard structures most of its ETFs as a separate share class of the related mutual fund, allowing both wrappers to benefit from the in-kind redemption tax advantage simultaneously. That patent expired in May 2023, and firms including Dimensional, Morgan Stanley, and Fidelity have since filed for their own ETF share classes of existing mutual funds.

The shift from mutual funds to ETFs is accelerating for a clear tax reason

More than $2 trillion in investor capital has left active mutual funds over the past two decades, with a similar amount flowing directly into exchange-traded funds instead. McInnis told Morningstar that the shift from mutual funds to ETFs among financial advisors has been substantial and shows no sign of reversing direction anytime soon.

Active ETFs now account for more than $800 billion in assets, and more than 400 new active ETFs launched in 2024 alone, according to Morningstar’s Stephen Welch research. 

For you, the takeaway is straightforward but critical. The wrapper you choose for your investments matters just as much as the investments themselves at tax time.

Every dollar lost to unnecessary capital gains distributions is a dollar that stops compounding for your future, and that cost adds up significantly over a full career.

Related: Vanguard Dividend ETF quietly outperforms amid market panic