Beating Uncle Sam: The Hidden Tax Advantages of Active ETFs

However, investors may want to rethink that stance in the modern era.

Active ETFs are starting to flip the script on tax management. Thanks to several benefits, active ETFs can reduce the taxes owed in a taxable brokerage account, helping investors score additional alpha while leaving Uncle Sam at bay.

While tax-deferred and tax-free investment accounts like 401(k)s and IRAs still hold the lion’s share of investor assets, the popularity of taxable accounts has risen over the last decade. It’s easy to see why. With no limitations on withdrawals or what these accounts can hold, several investors have been drawn to taxable accounts for their investments, both long and short-term. You can use it for retirement, education, buying a new motorcycle, or for an emergency—it doesn’t matter when or how you tap into it.

But there is a slight problem with taxable accounts. Uncle Sam gets a piece of all activity within the account. That includes dividends and capital gains.

Several investors have been drawn to passive or index ETFs for their taxable accounts. Because index ETFs can track entire market segments and usually hold a large number of stocks or bonds, they don’t trade their holdings frequently. This leads to lower capital gains liability, working favorably in a taxable account where taxes are owed every year.

Active fund managers do not usually deploy a “buy-and-hold” strategy, as they prefer the flexibility to sell assets for various reasons. For example, when a stock hits a predetermined price point or when a bond becomes overvalued, an active manager can raise cash by selling those securities. All of these sales are considered taxable events by the IRS.

The interesting thing is, those taxable liabilities from active management are quickly becoming a thing of the past. That’s because the ETF structure and active ETFs help eliminate several of these tax issues.

The pooling of the capital and rules enacted under the Investment Company Act of 1940 make mutual funds a poor choice for a taxable account—even passive ones. That’s because investors are all “mutual” owners of the fund. Whatever happens in the fund, investors are on the hook for, and at the end of the year, the mutual fund pays out gains to its shareholders. Those capital gains can be taxed at both long and short-term capital gains rates, depending on the fund’s holding period. The biggest insult to injury might be that even if you have a loss on the mutual fund investment, you may still have to pay capital gains on the sales based on what happened within the fund during the year.

ETFs tweak the rules of the Investment Company Act of 1940 and add additional layers to the structure. Here, authorized participants (APs) — registered, self-clearing broker-dealers — package the underlying stocks, bonds, or other holdings into so-called creation units. The AP delivers these to the fund sponsor, who bundles the securities into shares of the ETF. The AP then places these shares on the secondary market. The reverse happens when a manager sells assets in the fund or an AP redeems their shares.

Those of us in the secondary market—i.e., buying and selling shares on the exchange—never see this process because it happens in kind. We never get hit with capital gains taxes, which helps drive an ETF’s overall tax efficiency compared to a mutual fund. That’s a significant deal considering the top marginal tax rate includes a 40.8% federal tax on short-term gains and a 23.8% tax on long-term gains.

This chart from T. Rowe Price shows just how tax-efficient and how little capital gains active ETFs have distributed over the last five years. ¹

Source: T. Rowe Price

What’s also worth noting is that several of those capital gains distributed by active ETFs were in funds that held esoteric asset classes, like derivatives or commodities. Most straight stock-picking active ETFs still didn’t pass on any gains.

The win is that ETFs’ lower cost structure actually allows active managers to outperform their passive benchmarks in many asset classes. And with lower taxes, investors can genuinely benefit from the additional alpha. The average top-quartile large-cap fund has beaten the S&P 500 by 0.82% per year over the last five years. However, on an after-tax basis, these funds have underperformed by a whopping 1.46%. By eliminating the taxes, investors can outperform.

But active ETFs aren’t done on the tax-savings front yet. They can be smartly used for tax-loss harvesting. Because investors control their gains or losses by selling shares of the ETF, not what is inside, they can potentially reap some tax savings and use those losses to help offset capital gains and perhaps income taxes at year-end.

The overall gist is that active ETFs can fit perfectly within a taxable account, run efficiently, and reduce the overall burden investors face. And they could do so, better than even some passive vehicles.

With the ability to reduce capital gains taxes and generate additional market-beating returns, investors may consider active ETFs in their taxable accounts. They don’t just have to use passive funds.

Now, not every active ETF is a good fit for a taxable account. Some asset classes are excellent for taxable accounts, regardless of their structure. Options, derivatives, and some fixed-income asset classes still generate higher income and taxes that ETFs can’t eliminate. But for stocks and some bonds, the choice is clear to go active.

These ETFs are sorted by their YTD total returns, which range from 3.1% to 18.4%. They have expense ratios of 0.17% to 0.70% and assets under management of $500 million to $42 billion. They are currently yielding between 0% and 9.7%.

All in all, taxable accounts offer investors several choices; however, they come with the cost of paying Uncle Sam. But active ETFs can help these investment accounts run more efficiently and generate higher returns. By using their structure, active ETFs can eliminate many capital gains and allow investors to keep more of their returns.

Passive indexing used to rule taxable accounts. But not anymore. Active ETFs can reduce capital gains. This removes a significant hurdle for taxable accounts and allows investors to win out over time.

¹ T. Rowe Price (September 2025). How active ETFs can help reduce a portfolio’s tax liability