Mutual funds vs ETFs

My standard advice for those new to investing is buy an index fund. Index funds track an index such as the Dow Jones Industrial Average, S&P 500, or the Russell 2000.

Index funds come in two forms: mutual funds and exchange-traded funds or ETFs. Although both kinds of funds pool investor money to buy equities, they're structured differently, with different impacts on your income and taxes.

Of course, mutual funds and ETFs aren't always index funds. Many funds follow a strategy or theme instead. For example, Vanguard's Dividend Growth Fund focuses on high-quality dividend-paying stocks that are wiling to increase their dividends over time. iShares Global Clean Energy ETF invests in clean energy companies from around the world.

How mutual funds work

Mutual funds pool investor money and use it to buy shares of stock. When an investor wants to withdraw money, fund managers sell shares held by the fund to return the investor's cash.

If those shares were sold at a gain, you may find a surprise capital gain distribution in your account, even if you didn't withdraw money from the fund. Such distributions can increase your taxable income if you hold your mutual fund in a taxable account.

How ETFs work

ETFs work a bit differently. I'll point you to ETFs Have a Tax Advantage Over Mutual Funds from Morningstar to explain their precise structural advantage. Here's the simplified version: when you buy or sell shares of an exchange-traded fund, you're trading with other investors — not contributing to or withdrawing from the fund.

In other words, your income isn't affected by other investors' decisions to withdraw money. You pay capital gains taxes only when you sell your shares for more than your purchase price. A fund manager doesn't have to sell shares, or keep a pool of free cash, in order to for you to cash out. This means they're more tax-efficient than mutual funds.

You do still have to pay taxes on any dividend income or distributions you receive. That's true for ETFs and mutual funds, unless you hold them in a tax-advantaged account (such as a retirement account).

Investment minimums

In addition to tax-efficiency, exchange-traded funds have another advantage: lower investment minimums.

Mutual funds often require a minimum investment amount. The Vanguard 500 Index Fund Admiral Shares fund, for example, requires a $3,000 minimum investment.

Compare that to the Vanguard S&P 500 ETF. You can invest in this ETF for the cost of one share — less than that if your broker lets you buy partial or fractional shares.

My advice that isn't advice

Here's where I remind you that I have no training or credentials as a financial advisor. I suspect that if you talked to one, however, they'd tell you what I'm going to tell you.

• Hold your mutual funds in tax-advantaged retirement accounts.
• If you have a taxable account, ETFs are probably the better choice.

Regardless of the account type you hold them in, look for funds with low expense ratios and no transaction fees.