Did you know that you can convert directly from mutual funds to exchange traded funds (ETFs) without incurring taxes? I didn’t. I’ve been operating under the impression that selling the mutual fund shares would be a taxable event.

What I didn’t realize is that, at least with Vanguard equity funds, the conversion of conventional shares of an index fund into the corresponding ETF is a tax-free event. Here’s the scoop, direct from Vanguard:

Can I convert conventional Vanguard mutual fund shares to Vanguard ETFs?

Shareholders of Vanguard stock index funds that offer Vanguard ETFs may convert their conventional shares to Vanguard ETFs of the same fund. This conversion is generally tax-free, although some brokerage firms may be unable to convert fractional shares, which could result in a modest taxable gain. (Bond ETFs do not allow the conversion of bond index fund shares to bond ETF shares of the same fund.)

Vanguard will charge $50 for each conversion. (This fee is waived for Flagship clients.) Your brokerage provider may charge an additional fee for this service. For more information, contact your brokerage firm, or call 866-499-8473.

Once you convert to Vanguard ETFs, you cannot convert back to conventional shares. Also, conventional shares held through a 401(k) account cannot be converted to Vanguard ETFs.

Source: The Vanguard Group

This appears to be similar to the conversion of regular fund shares into “Admiral Shares” once your portfolio grows large enough. This is an attractive option for two reasons:

1. ETFs generally have lower expense ratios than index funds, and
2. ETFs aren’t subject to the year-end distribution of taxable gains

The fact that you can’t make the conversion within a 401(k) isn’t a huge deal, as year-end distributions within a tax-sheltered account aren’t taxable.

As for the $50 fee, I suspect that’s in place to encourage people to wait and convert larger chunks rather than buying index fund shares and then immediately converting to the corresponding ETF following each transaction. Do so would allow you to dodge brokerage commissions, but would also create an unnecessary burden on Vanguard.