We often compare ETFs to individual stocks, especially when it comes to how their prices change throughout the day.

But when it comes to capital gains, ETFs are much more like mutual funds: Even if you didn’t sell any ETF shares during the year, you may still be subject to capital gains taxes because the ETF itself could be generating gains from within the fund. Taxes are applied to a percentage of the total distribution.

Use ETFs to make your portfolio more tax-efficient

See which ETFs may be right for you

How often do ETFs make capital gains distributions?

The good news is that, although ETFs have to distribute a net realized gain from the year, it’s actually rare. For example, as of December 31, 2017, the overwhelming majority (85%) of Vanguard ETFs® had made no capital gains distributions in 5 years.

Get details on Vanguard ETF® distributions

So don’t be wary of ETFs because of the possibility of capital gains distributions. Instead, understand why they could happen in the first place.

Where do an ETF’s capital gains come from?

As you may know, capital gains are profits that come from selling an investment for more than its original purchase price. But it’s not just your sales that could generate those profits. Capital gains could come from within the ETF itself.

Similar to index mutual funds which have been popular for decades, the vast majority of ETFs are indexed. An ETF manager’s job is to make sure the ETF tracks its benchmark index—such as the S&P 500—as closely as possible and to ensure the makeup of the fund remains true to the index. To accomplish this, an index ETF buys all (or a representative sample) of the stocks or bonds that make up the index.

When the index shifts—let’s say, by changing its stocks or bonds or the weighting of each holding—the manager matches those shifts to maintain the same composition in the ETF.

Each time the manager has to sell something to keep up with the index, there could be a capital gain or a capital loss. At the end of the year, the manager adds up all of the gains and subtracts all of the losses. If the net gain exceeds the net loss, the gain must be paid out to the ETF’s shareholders (usually at the end of each year, with the possibility for some supplemental payouts in March). If the losses are greater than the gains, the manager can carry over the net loss to offset future gains.

ETF capital gains & losses accumulated throughout the year

What makes ETF capital gains distributions so rare?

Because most ETFs are trying to track specific indexes, they generally only add or remove stocks or bonds when the index does (or in the case of bond ETFs, when a bond matures and needs to be replaced).

Most indexes remain fairly constant, without a lot of turnover. When the index isn’t changing much, neither is the ETF. Fewer or smaller sales mean fewer possibilities for capital gains, which could ultimately lead to less taxable income for you.

Additionally, there are benefits related to how an ETF transacts in shares behind the scenes to meet redemptions from investors. When enough investors want to redeem, the ETF sends security shares sitting at a lower cost basis to Wall Street dealers. This purges the portfolio of shares that might’ve been more likely to be sold at a gain. This mechanism matters for limiting capital gains, though lower turnover may matter more.

Can you reinvest your capital gains distributions?

Yes! The Vanguard Brokerage dividend reinvestment program is a free service that lets you reinvest capital gains and dividend distributions in additional shares of the same ETF. The distributions are still taxable, but the proceeds of the distributions go back into your account and back to work for you.

The reinvestment price of new shares is determined when the brokerage places a market order as soon as the markets open on the distribution’s payable date.

Of course, if you need the income to help cover your living expenses (for example, in retirement), you don’t have to reinvest the distributions back into the ETF. You can simply wait until the distributions are deposited into your settlement fund and, as needed, transfer them to your bank from there.

Are your own trading habits affecting your taxes?

Simply put, short-term trading could be detrimental to your tax bill.

Unless your money is in a tax-deferred account (such as an IRA), all of the profits you make off a sale are considered capital gains. You made money (that’s a good thing!), but the IRS considers that taxable income (not so great). And you’re taxed on it the same way, whether the ETF distributed the capital gain to you or your own sale of shares resulted in a gain.

How much you’re taxed on that income starts with one basic factor: time.

Type of gain

Holding period

Current tax rates

Short-term capital gain

Less than one year

Range from 10% to 37%

Long-term capital gain

One year or more

Range from 0% to 20%

Visit irs.gov to get details on how your income and marital status also affect your tax rates.

Ready to give ETFs a try?

When you combine tax efficiency with low costs and broad diversification, it’s no wonder why ETFs have become increasingly attractive to all types of investors. Sure, investing in individual stocks eliminates capital gains distributions. But an ETF’s built-in diversification—and the lower risk that may result—could be far more impactful on your long-term investment success.

Now that you understand how ETF capital gains distributions work, consider which Vanguard ETFs might help you achieve your investment goals.


All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free) or through another broker (which may charge commissions). See the Vanguard Brokerage Services commission and fee schedules for full details. Vanguard ETF Shares are not redeemable directly with the issuing fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.

You may wish to consult a tax advisor about your situation.