ETFs are touted for their tax efficiency, and while they are more tax efficient than, say, a mutual fund, they can still incur taxes on their distributions. Come tax season, many ETF investors learn the hard way that not all distributions are created equal, and it’s worth it to appreciate the nuances of taxes on ETF distributions.
How Are ETFs Tax-Efficient?
We talk about ETFs as tax-efficient investment vehicles, because they minimize capital gains distributions due to their creation and redemption mechanism.
When an authorized participant redeems shares of an ETF due to market making activity or selling pressure, they typically receive the underlying securities in an “in-kind” transaction (rather than the ETF issuer selling the securities and returning cash). Since no underlying securities are sold, there is no taxable event for the ETF itself, even if the basis of those in-kind securities is low enough that there might have been a gain if sold. This keeps the tax basis of many ETFs inching ever higher, protecting the ETF from future capital gains.
In comparison, when shares of a mutual fund are redeemed, securities often must be sold to raise enough cash to pay out the exiting shareholder. That triggers tax events for the rest of the shareholders of the mutual fund.
How Do Taxes For ETF Capital Gains Distributions Work?
However, selling your own shares of an ETF at a profit will trigger capital gains, just like selling any other stock. What’s avoided is capital gains generated from the internal selling of securities within the fund itself.
By law, these capital gains have to be distributed every year to investors. This happens once a year, typically in December, and fund issuers release yearly updates as to which of their funds incurred capital gains. This capital gains distribution is in addition to any distributions that might have been made from dividends, coupon payments, or income from activities like selling futures — generally speaking, that’s income you can’t defer paying taxes on.
If a shareholder owns the shares of the ETF they sold for less than a year, then those capital gains are taxed as ordinary income on a 1099, maxing out at 37% depending on income level.
If the ETF shares are owned for longer than a year, then the tax burden is generally less for most investors, based on long-term capital gains rates. Long-term capital gains tax rates max out at 23.8% (including the Net Investment Income Tax for high-earning individuals) based on an investor’s taxable annual income.
How Do Taxes For ETF Dividend Distributions Work?
Often, the underlying securities held by an ETF will pay out dividends or generate other forms of income, which the ETF must then pass on to the shareholder, typically on a quarterly or monthly basis. These are handled in a variety of ways, but it is up to the individual issuer regarding how frequently they distribute the dividends earned across the underlying securities of the ETF.
Dividends are divided into two different types, qualified and nonqualified. Each has its own tax treatment.
Qualified dividends are reported to the IRS as long-term capital gains, if the underlying security that generated the dividend was held for more than 60 days before the ex-dividend date by the investor.
Qualified dividends must meet three requirements to be considered as long-term capital gains: They cannot be listed with the IRS as an unqualified dividend; they must be generated from a U.S. company or qualified foreign company; and they must meet the required holding period (the 60-day requirement). Additionally, they cannot be tied to hedging of any sort.
Meanwhile, unqualified dividends are taxed at the ordinary income rates of the individual investor. Dividends from REITs, most bonds, and currency or commodity hedging activity are all considered unqualified and taxed at ordinary income rates.
What Exceptions Are There To The Usual Taxes On ETF Distributions?
There are some exceptions to these generalized rules: ETFs that invest in precious metals are taxed as investments in collectibles (28% no matter how long you hold), while some commodities ETFs that deal in futures are considered partnerships, which will return a K-1 partnership income form requiring mark-to-market and annual tax payments.
Another exception is “return of capital” distributions, which are tax-deferred; the investor won’t pay taxes on these distributions until the holding itself is sold.
One other exception of note are muni bond distributions; munis are a special class of government bond whose distributions are tax-free.
At the end of the day, it’s on the investor to fully understand how their ETF might be taxed. The good news is that for the vast majority of plain-vanilla stock-and-bond ETFs, there’s no better vehicle to minimize your current year tax bill. If you’re straying further afield, just make sure you look under the hood.
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