Etfs
July 17, 2023 Emily Doak
Different ETF structures have different tax implications. Be informed and avoid unpleasant surprises come tax time.
Exchange-traded funds (ETFs) have a well-deserved reputation for tax efficiency, but a close look at how the tax code treats different ETFs reveals quite a bit of complexity. To better understand the ins and outs of capital gains distributions, dividends, interest, K-1 statements, collectibles tax rates, and more, read on. You could potentially save money at tax time.
Equity and bond ETFs: Capital gains
ETFs owe their reputation for tax efficiency primarily to passively managed equity ETFs, which can hold anywhere from a few dozen stocks to more than 9,000. Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
This is in large part because most ETFs passively track the performance of an index—which means they typically rebalance their holdings only when the underlying index changes its constituent stocks—whereas mutual funds are more likely to be actively managed. ETF managers also have options for reducing capital gains when creating or redeeming ETF shares.
That said, ETFs that hold dividend-paying stocks will ultimately distribute earnings to shareholders—usually once a year¬—while dividend-focused ETFs may do so more frequently. Qualified dividends may be taxed at lower capital gains rates if certain conditions are met—otherwise, you'll be taxed at the ordinary income rate, which tops out at 40.8%. Interest distributed to shareholders by bond ETFs—monthly, in many cases—is also taxed as ordinary income.
If you sell an equity or bond ETF, any gains will be taxed based on how long you owned it and your income. For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners.1 If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.
Commodity ETFs: K-1s and the 60/40 rule
ETFs that invest in commodities—such as oil, corn, or aluminum—do so via futures contracts, primarily because holding the physical object in a vault is impractical.
Futures can have a big impact on your portfolio's returns because of contango and backwardation—that is, whether the included futures contracts are more expensive than the market price of the commodity (contango) or less expensive (backwardation). As futures contracts in the fund expire, the ETF may have to replace those expiring holdings with new ones, potentially taking a loss in some cases (contango) or a gain in others (backwardation). In addition, futures come with their own tax implications.
Many ETFs that use futures are structured as limited partnerships and will report your income on Schedule K-1 instead of Form 1099. K-1s can be more complex to handle on a tax return, and the forms usually tend to arrive sometime after most 1099s become available. While uncommon, you may also need to worry about incurring unrelated business taxable income (UBTI) from your limited partnership investments, even if you hold the ETF within a traditional IRA. (See IRS Publication 598 for more information.)
Another noteworthy tax feature of commodity ETFs is the 60/40 rule, which states that any gains or losses realized by selling these types of investments are treated as 60% long-term gains (up to 23.8% tax rate) and 40% short-term gains (up to 40.8% tax rate). This happens regardless of how long you've held the ETF.
The blended rate could be an advantage for short-term investors (because 60% of gains receive the lower long-term rate) but a disadvantage for long-term investors (because 40% of gains are always taxed at the higher short-term rate).
At the end of the year, the ETF must "mark to market" all of its outstanding futures contracts, treating them—for tax purposes—as if the fund had sold those contracts. If some contracts have appreciated in value, the ETF will have to realize those gains and distribute them to investors— who must then pay taxes on the gains following the 60/40 rule.
To avoid the complexities of the partnership structure, newer commodity ETFs typically invest up to 25% of their assets in an offshore subsidiary (usually in the Cayman Islands). Although the offshore subsidiary invests in futures contracts, the IRS considers the ETF's investment in the subsidiary to be an equity holding.
With the rest of its portfolio, the ETF may hold fixed-income collateral (typically Treasury securities) or commodity-related equities. This allows the fund to be structured as a traditional open-end fund, which won't distribute a K-1 and is taxed like an equity or bond ETF at the same ordinary income and long-term capital gains rates.
Precious metals ETFs: Collectibles tax rate
ETFs focused on precious metals such as silver and gold involve a different set of tax issues. ETFs backed by the physical metal itself (as opposed to futures contracts or stock in mining companies) are structured as grantor trusts, which do nothing but hold the metal—they don't buy and sell futures contracts or anything else.
The IRS treats such ETFs the same as an investment in the metal itself, which would be considered an investment in collectibles. The maximum long-term capital gains rate on collectibles is 31.8% (including the NIIT), and short-term gains are taxed as ordinary income.
ETFs not structured as a trust backed by the precious metal are treated like a commodity ETF, so be aware of the type of precious metals ETF you hold to avoid surprises on your tax bill.
Currency ETFs
Currency ETFs come in several different forms and are taxed accordingly. ETFs structured as open-end funds, also known as '40 Act funds, are taxed up to the 23.8% long-term rate or the 40.8% short-term rate when sold.
Gains from selling currency ETFs structured as grantor trusts are always treated as ordinary income (currently up to the 40.8% rate) while those structured as limited partnerships are taxed using the 60/40 rule.
With currency ETFs, be sure to read the fund's prospectus to see how it will be taxed.
Should you invest in exchange-traded notes (ETNs)?
Instead of being backed by a portfolio of securities that are independent from the assets of an ETF manager, exchange-traded notes (ETNs) are bonds backed by the credit of the issuer. If the issuer is unable to repay the ETN shareholders, the shareholders will lose money. That's why we often caution investors to carefully consider credit risk before investing in ETNs.
Because ETNs don't hold securities of an underlying index, they generally don't distribute dividends or interest. However, when you sell an ETN, you could still be subject to short- or long-term capital gains taxes.
The tax implications of selling equity, bond, and commodity ETNs are similar to their ETF equivalents.
How are ETFs and ETNs taxed?
The table below gives a quick recap of tax rates for the various ETFs and ETNs we discussed:
How are ETFs and ETNs taxed?
Tax rates for the various ETFs and ETNs
- Type of ETF or ETN
- Tax treatment on gains
-
Type of ETF or ETN
Equity or bond ETF
>
Tax treatment on gains
Long-term: up to 23.8% maximum*
Short-term: up to 40.8% maximum
>
-
Type of ETF or ETN
Precious metal ETF
>
Tax treatment on gains
Long-term: up to 31.8% maximum
Short-term: up to 40.8% maximum
>
-
Type of ETF or ETN
Commodity ETF (limited partnership)
>
Tax treatment on gains
Up to 30.6% maximum, regardless of holding period
(Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate)
>
-
Type of ETF or ETN
Commodity ETF (open-end fund)
>
Tax treatment on gains
Long-term: up to 23.8% maximum*
Short-term: up to 40.8% maximum
>
-
Type of ETF or ETN
Currency ETF (open-end fund)
>
Tax treatment on gains
Long-term: up to 23.8% maximum*
Short-term: up to 40.8% maximum
>
-
Type of ETF or ETN
Currency ETF (grantor trust)
>
Tax treatment on gains
Ordinary income (up to 40.8% maximum), regardless of holding period
>
-
Type of ETF or ETN
Currency ETF (limited partnership)
>
Tax treatment on gains
Up to 30.6% maximum, regardless of holding period
(Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate)
>
-
Type of ETF or ETN
Equity or bond ETN
>
Tax treatment on gains
Long-term: up to 23.8% maximum*
Short-term: up to 40.8% maximum
>
-
Type of ETF or ETN
Commodity ETN
>
Tax treatment on gains
Long-term: up to 23.8% maximum*
Short-term: up to 40.8% maximum
>
- Source:
IRS.gov.
Tax rates include the 3.8% Net Investment Income Tax (NIIT) that is applied to investment income if your overall modified adjusted gross income (MAGI) is above $200,000 for single filers or head of household, $125,000 for married filing separately, and $250,000 for married filing jointly or a qualifying widow(er) with a dependent child. This is often referred to as the "Medicare surtax" and is layered on top of the other income tax rate you owe on that income.
*Up to a 20% tax rate on net capital gains applies to the extent that a taxpayer's taxable income for 2023 exceeds $578,125 for single filers, $693,750 for married filing jointly or qualifying widow(er), $578,100 for head of household, and $346,875 for married filing separately.
What does it all mean?
These tax rates only apply if you hold ETFs and ETNs in a taxable account (like your brokerage account) rather than in a tax-deferred account (like an IRA). If you hold these investments in a tax-deferred account, you generally won't be taxed until you make a withdrawal, and the withdrawal will be taxed at your current ordinary income tax rate.
If you invest in stocks and bonds via ETFs, you probably won't be in for many surprises. Investing in commodities and currencies is certainly more complicated. As more exotic ETFs come to market, we'll possibly see new tax treatments, and no tax law is ever set in stone. Always consult with your tax professional for any questions about the taxation of ETFs.
1The income threshold for NIIT is $200,000 for single filers or head of household, $125,000 for married filing separately, and $250,000 for married filing jointly or a qualifying widow(er) with a dependent child.
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Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling Schwab at1-800-435-4000. Please read it carefully before investing.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value. Commodity-related products are also subject to unique tax implications such as additional tax forms and potentially higher tax rates on certain ETFs.
Exchange-Traded Notes (ETNs) are distinct from Exchange-Traded Funds (ETFs). ETNs are debt instruments backed by the credit of the issuer and bear inherent credit risk. In some instances, ETNs can be subject to early redemption prior to maturity at the issuer's discretion. Therefore, their value when called may be less than the market price that you paid or even zero, resulting in a partial, or total, loss of your investment. ETNs are not generally appropriate for the average investor. To find out more about ETNs, please read Exchange Traded Notes: The Facts and the Risks.
Currencies are speculative, very volatile and not suitable for all investors.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Investing involves risk including loss of principal.
The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guarantee. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Futures trading involves a high level of risk and is not suitable for all investors. Certain requirements must be met to trade futures. Please read Risk Disclosure Statement forFutures and Options before considering any futures transactions.
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