Tax Advantage over Mutual Funds
- ETFs enjoy a deferred tax advantage as compared to mutual funds because ETFs are taxed when the entire investment is sold whereas a mutual fund incurs capital taxes everytime the assets in the fund are sold.
- Mutual funds incur more capital gains taxes than ETFs because of a higher frequency in trading activities.
Plain vanilla ETF’s
- In general ETFs are taxed like any other single stock – at the normal income tax rate if held for less than a year and at the long-term capital gains rate for more than one year – with the tax payable only at the time of sale.
- However, where ETFs pay dividends, earn an interest, are commodity or currency related among other variations – the tax treatment can get more complicated and investors should do their due diligence before investing.
Additional Tax treatments
- Dividend Paying ETFs – Taxes on dividend paying ETFs will vary depending upon whether the dividends are ‘qualified’ or ‘unqualified’. Unqualified dividends are those that the government does not recognize as true dividends (e.g. dividends on Money market accounts)
- International Fixed Income ETFs – If you want to invest in International Bond ETFs, you will have to research each ETFs country of origin and find out what kind of bond-related tax laws they have because the profits earned outside United States are subject to different tax rates and regulations than the profits earned in America.
- Physically Backed Commodity ETFs – the IRS taxes physically backed commodity ETFs (e.g. SLV, IAU) as collectibles, which get a higher long-term cap gains rate of 28%, not the lower 15% charged to stocks. (“Long term” means you hold it for at least a year.)
- ETFs that use Futures/ Forward contracts – For commodity ETFs that utilize futures contracts 60% of any gains are taxed at the long-term capital gains rate while the remaining 40% of gains are taxed as short term, which are subject to the investor’s ordinary income tax rate. For taxpayers in the highest marginal bracket, that results in a maximum blended tax rate of 23%, regardless of holding period.
- ETFs that Track Currencies – Currency ETFs aren’t funds at all but, rather, trusts or limited partnerships that pass income and gains through to their investors. If you are an investor in a Currency ETF you will receive a K-1 for the year that will itemize each specific type of income and expense passed through to you, the investor. The tax treatment of such income or gains depends on the Fund’s underlying positions, so you must read the prospectus to understand the tax treatment of such income, expense, gain or loss.
- ETNs – Ordinary capital gains and losses are realized and taxable – upon the sale of ETNs held long, upon the covering purchase of ETNs sold short, or when ETNs are redeemed or matured. ETNs are senior long-term debt instruments issued by a bank or financial institution that promises to pay investors the note’s face amount at maturity, adjusted for the performance of a particular commodity index. These are zero-coupon issues; they make no income distributions prior to maturity.