Exchange traded funds (ETFs) have continued to receive plenty of investor support as they offer plenty of tax benefits over traditional mutual funds. Thanks to their structure and the creation redemption mechanism, ETFs allow their investors to remove much capital gains exposure from their portfolios. But ETFs aren’t the only fund structure that allows for plenty of tax advantages.
Closed-end funds (CEFs) offer plenty of tax breaks as well. And in come cases and asset classes, those tax breaks may be more advantageous than ETFs.
For investors using a taxable account, CEFs could be a great choice to minimize what they owe Uncle Sam, possibly boosting returns and income potential.
The Structure Is Key
For ETFs, their tax benefits come from their structure. ETFs tweak the Investment Company Act of 1940 and add more layers to their structure, chief of which is the creation/redemption mechanism. Authorized participants (APs) are able to create ETF shares as well as receive in-kind assets when fund managers sell or reconfigure an index. As a result, those of us who participate in the secondary market don’t realize those capital gains.
It turns out ETFs aren’t the only fund vehicle that benefits from structure. Closed-end funds (CEFs) can also use their structure for unique tax benefits.
CEFs are created via an IPO with a fixed number of shares. Managers then use those proceeds to buy assets according to their mandate. The shares of the CEF are subsequently traded on the major exchanges. Capital from investors doesn’t flow in or out of the fund.
That’s huge when it comes to managing taxes.
That’s because CEFs tend to invest in various illiquid asset classes and hold those assets till maturity. In addition, managers within the fund can focus on reducing short-term gains. This chart from Nuveen highlights the last five tax types for many popular CEF subcategories.
Source: Nuveen
Those Tax Benefits in Practice
So how do CEFs actually benefit investors when it comes to taxes and how can we use the fund structure to our advantage?
For starters, one of the biggest subcategories of CEFs is municipal bonds. And that makes sense due to the illiquid nature of the asset class. Munis feature interest that is tax-free from federal taxes and, in some cases, state taxes. Thanks to CEFs’ ability to use leverage in their portfolios, investors can get more tax-free yield from a CEF than an ETF or mutual fund.
CEFs could allow investors to avoid another municipal bond headache known as the de minimis rule. This rule determines whether the price appreciation of a muni security purchased at a discount will be taxed as ordinary income or the capital gains. The vast bulk of municipal bond managers purchase securities at slight premiums to par values and include this fact in their mandates. The win is that you or I can buy the CEF at a discount to its net asset value. Whether or not the bonds inside the CEF are trading below par is a different matter. This allows investors to buy premium priced assets at discounts and avoid the de minimis rule potential.
Second, investors looking at commodities, gold bullion or master-limited partnerships (MLPs) can win on the tax front as well. Gains on precious metals and ETFs holding gold, silver, platinum, etc., are taxed as collectibles up to 28%. However, sales of CEFs aren’t treated as such, allowing investors to pay long- term gains tax rates if held for a year or more. Likewise, MLPs held in a CEF aren’t considered partnerships and investors won’t receive a K-1 statement come tax time, with many distributions being at advantageous dividend tax rates.
Then there is arguably the biggest CEF tax benefit: managed distribution plans. A managed distribution plan allows a CEF to pay actual and expected capital gains throughout the year, not just as a single year-end distribution. This allows them to monetize total returns today rather than later on.
Because of this, not all of their distributions will come from net investment income and capital gains. Some come back to investors as an untaxed return of capital. Return of capital reduces an investor’s cost basis in an investment, and essentially defers the tax owed until the security is sold or the cost basis reaches $0, potentially years down the line. The added bonus is managers of the fund are able to offset losses to offset gains, and as long as they are earning their targeted distribution, investors are able to get total returns untaxed.
These benefits can make a CEF potentially more tax friendly than a comparable ETF and more tax beneficial than a mutual fund.
Using CEFs as a Tax-Smart Investment
While ETFs have been getting all the praise as the tax-smart investment of choice, CEFs can provide pretty hefty tax wins as well. Investors shouldn’t be so quick to bypass them in favor of other fund structures. To that end, it makes a ton of sense to incorporate them into your portfolio.
For example, a municipal bond CEF may provide more tax-free income than an ETF or a high-yield bond CEF’s non-destructive return of capital could provide investors an income boost while deferring taxes for a long while. Using CEFs in concert with ETFs could be a win-win for many investors looking to combat Uncle Sam.
Running our screener here at Dividend.com can provide plenty of CEFs with strong yields and potential tax benefits.
Top-Performing CEFs
These CEFs are sorted by their YTD total returns, which range from 6.5% to 15.8%. They have AUM between $93M and $1.65B and expenses between 0.83% and 3.4%. They are currently yielding between 6.1% and 13.1%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type |
|---|---|---|---|---|---|---|
| XAGIX | abrdn Global Infrastructure Income Fund | $610M | 15.83% | 12.66% | 2.04% | CEF |
| XAEFX | abrdn Emerging Markets ex-China Fund | $344M | 13.02% | 10.4% | 2.04% | CEF |
| XIAFX | abrdn Australia Equity Fund | $130M | 12.07% | 10.4% | 1.94% | CEF |
| XJEQX | abrdn Japan Equity Fund | $93M | 11.97% | 6.09% | 0.83% | CEF |
| XBGRX | BlackRock Energy Resources Trust | $380M | 9.6% | 6.1% | 1.29% | CEF |
| XJQCX | Nuveen Credit Strategies Income Fund | $790M | 9.2% | 13.1% | 2.67% | CEF |
| XJFRX | Nuveen Floating Rate Income Fund | $1.22B | 8.7% | 12.8% | 3.4% | CEF |
| XBGTX | BlackRock Floating Rate Income Trust | $285M | 8.2% | 12.1% | 3.05% | CEF |
| XBDJX | BlackRock Enhanced Equity Dividend Trust | $1.65B | 7.3% | 9.1% | 0.86% | CEF |
| XJLSX | Nuveen Mortgage and Income Fund | $104M | 7% | 10.8% | 1.57% | CEF |
| XJPCX | Nuveen Preferred Income Opportunities Fund | $783M | 6.5% | 9.3% | 2.68% | CEF |
Overall, CEFs can be a tax-efficient choice for investors. From higher-yield portfolios of tax-free muni bonds and lower rates for esoteric assets to cost-reducing returns of capital, the fund structure can be used by investors to lower what they owe Uncle Sam. And ultimately, the less you pay, the bigger your income and returns will be.
The Bottom Line
Closed-end funds can be a very tax-smart portfolio vehicle. Thanks to their structure and several key tax benefits, CEFs can deliver a better after-tax return than many other fund vehicles. This can include ETFs in certain asset classes and sectors.
1 Financial Planning (June 2025). Closed-End Funds: From All Angles
