When investing in the stock market, knowing how you’ll need to pay taxes is important. Capital gains taxes are a reality for anyone buying and selling stocks. But what if you’re trading in funds like ETFs? Did you know that ETFs have different tax implications depending on how they’re structured and what investment they include? Here’s what you need to know about how ETFs are taxed.
Need help finding tax-efficient ETFs for your portfolio? Consider working with a fiduciary financial advisor.
What Are ETFs?
Exchange-traded funds (ETFs) are a bundle of securities that offer the diversity of a mutual fund and the ability to be traded like a stock. ETFs are essentially bundles of investments that are specifically put together to track a market index, such as the S&P 500. There are hundreds of unique ETFs traded on U.S. markets, each specializing in a different approach.
In general, ETFs are great picks for beginners and investors who want to set it and forget it. They have fewer fees and minimums than many mutual funds, and they offer the diversification that a well-balanced portfolio needs.
Realized Gains or Losses From the Sale of ETF Shares
ETFs can offer added efficiency come tax time. If you know how ETF taxes work, it can save you a lot of money. However, it’s important to keep in mind that different ETFs face different tax rates.
Remember, short-term capital gains are the profits derived from an asset that’s sold within a year of purchase. They are taxed as ordinary income. Long-term capital gains, on the other hand, are the profits realized when you sell an asset you’ve held for more than a year. Long-term gains get a more favorable tax treatment and are taxed at 0%, 15% or 20%, depending on your income.
Note that individuals with substantial income will face an additional 3.8% net investment income tax (NIIT). This is included in the percentages below. Let’s break down how different ETFs are taxed:
- Equity and Bond ETFs: These ETFs top out at normal short- and long-term capital gains rates. That means if you sell after holding for less than a year, you can be taxed up to 40.8%. For those held for longer than a year, your maximum tax rate is 23.8%.
- Precious metals ETFs: The IRS taxes ETFs that invest in precious metals like they were precious metals themselves. That means they’re taxed as collectibles. Long-term capital gains tax on collectibles goes up to 28% (NIIT included), higher than the 23.8% capital gains tax on an equity ETF for the highest-income earners. Short-term capital gains are still taxed at the normal income rate.
- Commodities ETFs: The taxation of commodity ETFs can be fairly complex. They deal in futures contracts and are often structured as limited partnerships. As a limited partnership, these ETFs send schedule K-1 forms instead of 1099s. The gains of commodity ETFs are also taxed at a blended rate – 60% long-term capital gains and 40% short-term. This is an upside for short-term investors, but a downside for long-term investors.
- Currency ETFs: Depending on the structure of the currency ETF, they could be taxed like equity ETFs, like commodities ETFs or, if they’re structured as a grantor trust, they could be taxed at the income tax rate.
What Happens When an ETF Passes on Realized Gains?
While ETFs are incredibly tax-efficient, that doesn’t mean they’re tax-free. They will pass on capital gains to their investors when the underlying assets perform well. This is referred to as a capital gains distribution. These are taxed at the long-term capital gains rate, even if you’ve held the fund for less than a year.
Capital gains distributions are typically made at the end of the year. You can reinvest them as shares in the fund or withdraw them. Regardless of whether you keep the distribution in the fund or pull it out, you will need to pay capital gains tax. If you want to avoid taxes, you could specifically invest in more tax-efficient funds that are less growth-focused.
How Dividend Payments Affect ETF Taxes
If you’re receiving dividend payments from your ETF, they’re being taxed in one of two ways. Ordinary dividends are taxed at your income tax rate, whereas qualified dividends are taxed at the lower long-term capital gains tax rate.
As their name suggests, ordinary dividends are much more typical. Unless noted otherwise, dividends from your ETF are probably ordinary. Qualified dividends require you to hold them for a specific time period and must be unhedged, meaning they can’t be in use for puts or calls.
While ETFs are generally regarded as tax-efficient assets, there are scenarios where you’ll realize gains and losses. It’s helpful to know how ETF taxes come into play. Depending on the structure of the ETF, the assets it contains, along with how long you’ve held it, different taxation rates could be applied if you sell your shares. If you’re receiving a capital gains distribution, the IRS will tax it at the long-term capital gains rate, no matter how long you’ve held it.
Tax Planning Tips
- Certain ETFs are more tax-efficient than others. Creating a strategy to maximize your investment gains can benefit from the assistance of a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re going to have capital gains, it’s good to estimate ahead of time how much you’ll owe. See how the gains you make when selling stocks will be impacted by capital gains taxes by using this free capital gains tax calculator.
- ETFs are a great option for beginners. They have low costs, can diversify your portfolio and are more accessible than other investment types. If you’re just getting started investing, check out our Investment Guide for Beginners.
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