Exchange traded funds 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 come to appreciate the importance of understanding the nuances of taxes on ETF distributions.
We talk about ETFs as tax-efficient investment vehicles because they minimize capital gains distributions due to their creation and redemption features. 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 are sold, and that triggers tax events for the rest of the shareholders of the mutual fund.
It’s important for advisors and investors to understand that selling shares of an ETF at a profit will trigger capital gains just like selling any other stock; what’s avoided is capital gains from internal selling of securities, which by law have to be distributed every year to investors. These capital gains are paid out once a year, typically in December, and issuers release yearly updates as to which of their funds incurred capital gains. This capital gains distribution is in addition to any distribution that might be made from dividends, coupon payments, or income from activities like selling futures — 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, it is taxed as regular income on a 1099 come tax time, maxing out at 37% depending on income level. If the ETF shares are owned for longer than a year, then the profit is generally taxed 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.
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 (sometimes monthly) basis. These are handled in a variety of ways, but it is up to the individual issuer regarding how frequently they want to distribute the dividends earned across the underlying securities of the ETF.
Dividends are divided into two different types, qualified and nonqualified, each with a different 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.
Unqualified dividends are taxed differently, namely at the regular income rates of the individual investor. Dividends from REITs, MLPs, most bonds, and currency or commodity hedging activity are all considered unqualified and taxed at the regular income rates.
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.
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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