An Overview – ETFs and Taxes
ETFs have a well-deserved reputation for tax efficiency, but a deeper look at how the tax code treats the various types of ETFs on the market reveals significant difficulty. ETFs owe their reputation for tax efficiency mostly to equity ETFs, which can contain anywhere from 25 to over 7,000 different stocks. In this way, equities ETFs are comparable to mutual funds, but they are generally more tax-efficient because they do not distribute a lot of capital gains.
This is due in part to the fact that most ETFs are managed passively by fund managers in relation to the performance of an index, whereas mutual funds are generally handled actively. When establishing or redeeming ETF shares, ETF managers have the option of decreasing capital gains.
Further Key Takeaways
Remember that ETFs that invest in dividend-paying companies will eventually release those dividends to shareholders—typically once a year, though dividend-focused ETFs may do so more regularly. ETFs that hold interest-paying bonds will release that interest to owners on a monthly basis in many situations.
Equity and bond ETFs held for more than a year are taxed at long-term capital gains rates, which can be as high as 23.8 percent. Ordinary income rates, which peak out at 40.8 percent, apply to equity and bond ETFs held for less than a year.
ETFs that invest in precious metals
Investors who use exchange-traded funds (ETFs) to get exposure to precious metals like silver and gold may face a separate set of tax difficulties. Grantor trusts, for example, are ETFs that are backed by the physical metal itself. The only thing a grantor trust does is keep metal; it doesn’t buy or sell futures contracts or anything else.
The tax department considers investment in a precious metals ETF to be the same as an investment in the metal itself, which would be deemed collectable for tax reasons. Collectables have a maximum long-term capital gains rate of 31.8 percent, which is higher than the 23.8 percent top capital gains rate on a stock ETF. Short-term gains on collectables, on the other hand, are taxed like ordinary income.
This isn’t to say you shouldn’t use precious metals to diversify your portfolio. To avoid unpleasant surprises, you should be informed of the various tax treatment options.
Futures contracts are used by ETFs that invest in commodities other than precious metals, such as oil, corn, or aluminium because storing the physical product in a vault is impracticable.
Because of contango and backwardation—that is, whether the futures contracts are more (contango) or less (backwardation) expensive than the market price of the commodity—the usage of futures can have a significant impact on a portfolio’s results. Furthermore, futures have tax implications.
The blended rate may be beneficial to short-term investors (since 60% of gains are taxed at the lower long-term rate), but it may be detrimental to long-term investors (because 40 percent of gains are always taxed at the higher short-term rate).
Furthermore, the ETF must “mark to market” all of its outstanding futures contracts at the end of the year, treating them as if the fund had sold them for tax reasons. As a result, if the ETF owns contracts that have risen in value, it will have to realise those gains for tax purposes and distribute them to investors (who will then have to pay taxes on the profits under the 60/40 rule).
Newer commodity ETFs have been developed that typically invest up to 25% of their assets in an overseas subsidiary to circumvent the complexity of the partnership structure (usually in the Cayman Islands). Despite the fact that the offshore subsidiary invests in futures contracts, the IRS considers the ETF’s investment in the subsidiary to be equity ownership.
Fixed-income collateral (usually Treasury securities) or commodity-related stocks may make up the rest of the ETF’s portfolio. This permits the fund to be organised as a regular open-end fund, which does not issue a K-1 and is taxed at the same ordinary income and long-term capital gains rates as a stock or bond ETF.
ETFs that invest in currencies
Currency ETFs are available in a variety of formats. Some, like most equities and bond ETFs, are organised as open-end funds. Gains from the sale of these funds are taxed in the same way that gains from equity and bond ETFs are: up to the long-term rate of 23.8 percent or the short-term rate of 40.8 percent.
Grantor trusts are used to structure other currency ETFs. Profits from the sale of these funds are always considered ordinary income. When it comes to currency ETFs, the bottom line is that you should read the prospectus to discover how the fund will be taxed.
Should you put your money into ETNs?
Before investing in exchange-traded notes, it is always advised to think about credit risk. ETNs are bonds backed by the issuer’s credit, rather than a portfolio of securities that are separate from the assets of an ETF management. As a result, if the issuer is unable to repay the ETN shareholders, they will lose money. It’s worth mentioning, though, that ETNs have their own tax implications.
ETNs do not pay dividends or interest because they do not hold equities in the underlying index. However, you may be subject to short- or long-term capital gains tax if you sell an ETN. Bonds and stocks are two types of investments. ETNs are similar to ETFs in that long-term profits are taxed at a rate of up to 23.8 percent and short-term gains are taxed as ordinary income.
Commodity ETNs are taxed similarly to equities and bond ETNs, with long-term profits taxed up to 23.8 percent and short-term gains taxed at the usual federal rate of up to 40.8 percent. The currency ETN is the genuine outlier here. The IRS has declared that profits from selling currency ETNs, like earnings from a grantor trust, will be taxed as ordinary income at up to 40.8 percent, even if held for a long time.
These tax rates apply only if you invest in ETFs and ETNs in a taxable account (such as your brokerage account), not a tax-deferred account. If you keep these investments in a tax-deferred account, you won’t be taxed on them until you withdraw them, at which point you’ll be taxed at your regular income tax rate.
You’re unlikely to be surprised if you invest in equities and bonds through ETFs. Commodity and currency investing is unquestionably more difficult. We may see new tax treatments as more exotic ETFs come to market, and no tax regulation is ever fixed in stone. If you have any queries regarding how ETFs are taxed, you should always consult a tax specialist.