David Eisenhauer is the founder and chief wealth strategist at Greykasell Wealth Strategies.
As I wrote about recently, pooled investments like mutual funds can create an unexpected tax bill for investors. This happens because of how such funds are structured.
When an investor sells a mutual fund, they sell it back to the company, which often must liquidate internal holdings to raise the cash to pay redemptions. And even if an investor does not sell, an actively managed fund will generally make changes that generate realized gains that then get distributed to shareholders.
In each instance, a capital gain can be triggered for everyone remaining in the pool.
ETFs, by contrast, trade like stocks on an exchange, so funds usually do not have to raise cash by selling holdings. When net selling is heavy, authorized participants can redeem shares with the fund through the creation and redemption mechanism, retiring ETF shares and receiving underlying securities rather than forcing the ETF to sell holdings for cash.
Comparing the Cost: Mutual Funds vs. ETFs
The “tax drag” below represents the portion of your return lost to annual taxes.
Active Mutual Fund vs. Comparable ETF
*Data from Morningstar, InvestmentNews, Invesco and Schwab to compile chart.
A Strategic Exit: The Donor-Advised Fund
As more investors become aware of this issue, they confront a form of tax-induced paralysis. While it is natural to want to avoid the immediate hit of a sale, staying put means recurring taxes gradually undermine long-term growth. A donor-advised fund (DAF) may offer a strategic way out of this trap.
By donating appreciated shares directly to a DAF, you eliminate the capital gains tax that would have been applied to unrealized gain if realized while supporting the causes you care about. You also receive a tax deduction for the full fair market value of the shares, limited to 30% of your adjusted gross income when donating appreciated securities.
This strategy effectively allows for a tax efficient re-allocation of capital. By donating the appreciated mutual fund, you remove the “tax-ugly” asset from your balance sheet entirely. You can then use your sidelined cash to purchase a more modern investment, such as an ETF, at its current market price.
This effectively “cleans” your portfolio of years of accumulated capital gains. Because your new cost basis is pinned to today’s higher price, any future growth starts from zero for tax purposes. If the market dips, you have a fresh opportunity to harvest losses. If it rises, your eventual tax bill may be significantly smaller.
The 2026 Deadline: A Closed Window
Beginning this year, the One Big Beautiful Bill Act (OBBBA) made giving more expensive from a tax perspective. A new deduction floor means your first dollars of annual charitable gifts may generate no tax benefit, and the value of any remaining deduction is effectively limited at a lower rate.
That is why moving away from tax-inefficient mutual funds is about more than a single rule change. In a higher-tax environment, tools like donor-advised funds and thoughtful basis management can help you control when gains are realized, reduce avoidable tax drag and keep more of your return working for you.
