Exchange traded funds (ETFs) have been touted as being tax efficient. While this is true, by and large, this does not mean that taxes are always low or that they are all even taxed the same. Knowing the differences can save you a lot of pain later.
The process of creation and redemption with ETFs is a large part of what makes them so tax efficient. When you redeem mutual funds, the manager needs to raise cash by selling shares within the fund. This results in capital gains for other investors in the fund. When an ETF is sold, no selling of shares takes place.
Hans Wagner for Investopedia reports that the trade itself does trigger a taxable event. The rate of taxation depends on how long the fund was held: if it’s more than a year, then a long-term capital gain/loss is in effect. [Not All ETFs Are Taxed The Same.]
Many ETFs also generate dividends; those are taxed, too. The ETFs are subject to the same maximum tax rate that applies to net capital gains. Your ETF provider should tell you whether the dividends that have been paid are ordinary or qualified, though most are ordinary. [Why Trading ETFs Is Better Than Trading Mutual Funds.]
There are exceptions to the tax rules, though. They’re seen particularly in non-equity ETFs, such as those below:
- Currency ETFs: Most currency ETFs are grantor trusts, meaning profits create a tax liability for shareholders. These profits are taxed as ordinary income.
- Futures ETFs: Gains and losses on the futures within the ETF are treated for tax purposes as 60% long-term and 40% short-term regardless of how long the contracts were held by the ETF.
- Metals ETFs: If you trade or invest in gold, silver or platinum bullion, the taxman considers it a “collectible” for tax purposes. The same applies to ETFs that trade or hold gold, silver or platinum. As a collectible, if your gain is short-term, then it is taxed as ordinary income. Long-term gains are taxed at 28%.
- Leveraged ETFs: Kevin Grewal for Daily Markets explains that these funds hold options and swaps secured by pools of cash and generate interest income from the cash which is taxed at ordinary income rates. Additionally, capital gains from these ETFs are taxed at short-term rates, regardless of holding periods.
This should not be construed as tax advice. If you’re seeking further guidance about ETFs and taxes, talk to your accountant.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.