Mutual funds and exchange-traded funds (ETF) offer many attractive benefits, including instant access to a collection of individual stocks that are managed by experts. They can be the ideal investment options if choosing your own stocks or losing all your money from one stock gives you nightmares. 

But before you declare mutual funds and exchange-traded funds as superior investments over all other assets, it's important to understand how they really work. There are some key differences to point out: in particular, how much you'll have to pay in taxes. The investments you choose will determine how often you are taxed, how much you pay in taxes, and the strategies you can use to "negotiate" your tax bill.

Dollar bag, financial products on balance scale e.g ETFs, REITs, stocks, commodities, bonds, mutual funds, depicts balancing between risk and return.

Image source: Getty Images.

How mutual funds and ETFs work 

It's not hard to see why mutual funds and ETFs have been a hit among investors. They offer portfolio diversification, convenience, and lower risk. Mutual funds have been around the block, dominating employer-sponsored retirement plans for years. On the other hand, ETFs are the new kids on the block and have been growing in popularity over the last decade, giving mutual funds stiff competition due to their tax efficiency. 

The taxes you pay on mutual funds and ETFs have a lot to do with their structure and activity. Mutual funds are considered pass-through entities. All this means is that income (capital gains and dividends) is passed through to investors as if they earned the money directly. Because investors get the profits, they also get the tax bill for any transactions that are executed by the fund manager on their behalf.

In contrast, the creation and redemption process for ETFs make taxes less of a headache. In a nutshell, ETF "in-kind" transactions don't trigger a taxable event because there is no cash involved. Stock ETFs are more tax-efficient than mutual funds, but you'll have to pay attention to more exotic ETFs such as precious metals and commodity ETFs because they can create a more complex tax situation. 

Besides the taxes, you'll also want to consider fees such as loads (aka sales charges or commissions) for actively managed mutual funds. Expense ratios are a hot topic for both mutual funds and ETFs. 

Capital gains taxes 

Mutual funds and ETFs that are not in a tax-advantaged account such as a Roth IRA will require you to consider taxes on an annual basis. The major difference between these two investment options is the frequency of the activity, leading to short-term or long-term capital gains.

When a mutual fund manager buys and sells assets, the fund has to distribute the gains to shareholders each year, leading to potential tax liability for the shareholders. Often, these gains for actively managed funds are received from investments held less than a year, which makes those distributions taxable at ordinary income tax rates that can be as high as 37%. You can avoid a colossal tax bill on mutual funds by simply pursuing passive mutual funds that track indexes and therefore don't generally buy or sell their holdings. 

Actively managed ETFs are becoming very popular, in large part due to Cathie Wood's ARK Innovation ETF (NYSEMKT:ARKK), which has produced a 500% return since inception. Beware: If you have actively managed ETFs in your portfolio, you might encounter some of the same tax problems as actively managed mutual funds.

But most ETFs are passively managed funds that typically track well-known indexes such as the S&P 500. The components of the S&P 500 rarely change, leading to lower taxable events and tax liabilities. ETF investments inherit the luxuries of stock investing, often unlocking favorable long-term capital gains rates of 0%, 15%, or 20% that give investors a reward for their patience. What makes ETFs even more appealing is they very rarely make any capital gains distributions, leaving the tax liability for when you sell your shares in the ETF. 

Don't forget about taxes on dividends  

Dividends are a great way to earn an extra stream of income from your investments. But timing matters when it comes to how much of that money you get to keep in your pockets. The magic holding period is 60 days. The dividend-paying stock must be held by the fund for more than 60 days before the ex-dividend date or any combination of 61 days within the 121-day period to be classified as a "qualified dividend".  

Dividends that are eligible for the "qualified" status are taxed at the same preferential tax rate as long-term capital gains. But if the stocks held by a mutual fund or ETF was held in a fund for 60 days or fewer in that key period, take a deep breath before you look at your tax bill. You have a nonqualified dividend. The dividend income will be taxed at higher ordinary income rates, which are the same tax brackets used to calculate the tax liability from working a job.

What to know during tax time

Your brokerage firm will send you a 1099 statement during tax time to ensure you record your profits and losses properly. 

If you have actively managed mutual funds, you may be surprised with more short-term capital gains because your fund manager engaged in frequent activity throughout the year to rebalance your portfolio. But if you have an ETF, you'll most likely enjoy more long-term capital gains because of the limited activity. 

Now that you understand how mutual funds and ETFs work, you can choose the best way to enjoy your profits without worrying about taxes. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.