How are ETFs taxed?

The convenience of buying and selling Exchange Traded Funds (ETF) and low transaction costs provide investors with an effective investment portfolio enhancement tool. Tax efficiency is another important part of its appeal. Investors need to understand the tax consequences of ETFs so that they can proactively develop strategies.

We will first explore the tax rules applicable to ETFs and the exceptions you should be aware of, and then we will show you some money-saving tax strategies that can help you get high returns and beat the market.

Taxation of ETF

Due to its unique structure, ETFs enjoy more favorable tax treatment than mutual funds. ETFs create and redeem shares through physical transactions that are not considered sales. Therefore, they will not generate taxable events. However, when you sell an ETF, the transaction triggers a taxable event. Whether it is a long-term or short-term capital gain or loss depends on how long the ETF is held. In the United States, to obtain long-term capital gains treatment, you must hold an ETF for more than one year. If you hold the security for one year or less, it will receive short-term capital gains treatment.

Dividend and interest payment tax

ETF dividends and interest payments are taxed similarly to income from underlying stocks or bonds. Income needs to be reported in your 1099 report. If you make a profit from selling ETFs, they will also be taxed like the underlying stocks or bonds.

ETFs held for more than one year are taxed at the long-term capital gain rate, up to 20%. Individuals who earn substantial income from investments may also pay an additional 3.8% net investment income tax (NIIT). ETFs held for less than one year are taxed at the ordinary income tax rate. The maximum tax rate in this range is 37%. In addition, some investors are required to pay a 3.8% NIIT.

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As with stocks, for ETFs, if you sell the ETF and buy it back within 30 days, you must follow the wash sale rules. When you sell or trade securities at a loss, and then within 30 days of the sale, you:

  • Purchase substantially the same ETF;
  • Obtain substantially the same ETF in a fully taxable transaction; or
  • Obtain a contract or option to purchase essentially the same ETF.

If your losses are banned due to wash sale rules, you should add the disallowed losses to the cost of the new ETF. This increases your base in the new ETF. This adjustment postponed the deduction of losses to the disposal of the new ETF. Your holding period for the new ETF starts on the same day as the holding period for the sold ETF.

Many ETFs generate dividends from their holdings. Ordinary (taxable) dividends are the most common type of distribution for companies. According to the IRS, unless the payment company states otherwise, you can assume that any dividends you receive from common stock or preferred stock are common dividends. These dividends are taxed when they are paid by the ETF.

The maximum tax rate for qualified dividends is the same as the tax rate applicable to net capital gains. Your ETF provider should tell you whether the dividends paid are ordinary dividends or qualified dividends.

Exceptions-currencies, futures and metals

As with almost everything, there are exceptions to the general tax rules of ETFs. A good way to consider these exceptions is to understand the tax rules of the industry. ETFs that are suitable for certain industries follow the tax rules of that industry instead of general tax rules. Currency, futures and metals are industries that enjoy special tax treatment.

Currency ETF

Most currency ETFs adopt the form of grantor trust. This means that the profits of the trust create a tax liability for ETF shareholders and are taxed as ordinary income. Even if you hold an ETF for several years, they will not receive any special treatment, such as long-term capital gains. Since currency ETFs trade in currency pairs, tax authorities may assume that these transactions are carried out in the short term.

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Futures ETF

These funds trade commodities, stocks, government bonds and currencies. For example, Invesco DB Agriculture ETF (DBA) invests in agricultural futures contracts—corn, wheat, soybeans, and sugar—rather than basic commodities. For tax purposes, futures gains and losses in ETFs are treated as 60% long-term and 40% short-term, regardless of how long the ETF holds the contract. In addition, ETFs that trade futures follow the market value rule at the end of the year. This means that unrealized gains at the end of the year are taxed as if they were sold.

Metal ETF

If you trade or invest in gold, silver or platinum bars, tax officials treat them as “collectibles” for tax purposes. The same applies to ETFs that trade or hold gold, silver or platinum. As a collectible, if your income is short-term, it is taxed as ordinary income. If your income exceeds one year, then you will be taxed at a higher capital gains tax rate of 28%. This means that you cannot take advantage of the normal capital gains tax rate for ETFs that invest in gold, silver or platinum. Your ETF provider will tell you what short-term gains or long-term gains or losses are.

Tax strategy using ETF

ETFs can help with effective tax planning strategies, especially when you have a mix of stocks and ETFs in your investment portfolio. A common strategy is to close losing positions before the first anniversary. Then, you hold a position that has earned more than one year. In this way, your income will receive long-term capital gains treatment, thereby reducing your tax liability. Of course, this applies to stocks and ETFs.

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In another situation, you may hold an ETF in an industry that you think is performing well, but the market has already driven down all industries, causing you a small loss. You are unwilling to sell because you think the industry will rebound, and you may miss the proceeds due to the wash-sell rules. In this case, you can sell the current ETF and buy another ETF that uses a similar but different index. In this way, you can still access favorable industries, but you can use the losses of the original ETF for tax purposes.

ETFs are useful tools for year-end tax planning. For example, you have a batch of loss-making materials and stocks in the healthcare industry. However, you think these industries are expected to outperform the market next year. The strategy is to sell stocks at a loss, and then buy industry ETFs that still give you exposure to the industry.

Bottom line

Investors who use ETFs in their investment portfolios can increase their returns if they understand the tax consequences of their ETFs. Due to their unique characteristics, many ETFs provide investors with the opportunity to defer taxes until the sale, similar to owning stocks. In addition, as you approach the first anniversary of buying a fund, you should consider selling the loss-making fund before the first anniversary to take advantage of short-term capital losses. Similarly, you should consider holding ETFs with earnings that exceed the first anniversary to take advantage of the lower long-term capital gains tax rate.

ETFs that invest in currencies, metals, and futures do not follow general tax rules. On the contrary, as a general rule, they follow the taxation rules for related assets, which usually results in short-term income tax treatment. This knowledge should help investors in tax planning.

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