ETFs and Taxes: What You Need to Know

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. If you want to understand the ins and outs of capital gains distributions, dividends, interest, K-1 statements, collectibles tax rates, and more, read on. You could save some money at tax time.

ETFs owe their reputation for tax efficiency primarily to equity ETFs, which can hold anywhere from a few dozen stocks to more than 7,000. 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 generally rebalance their holdings only when the underlying index changes its constituent stocks—whereas mutual funds are generally 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 those dividends to shareholders—usually once a year, although dividend-focused ETFs may do so more frequently. ETFs holding bonds that pay interest will also distribute that interest to shareholders—monthly, in many cases. The IRS taxes dividends and interest payments from ETFs just like income from the underlying stocks or bonds, with the income being reported on your 1099 statement. 

Profits on ETFs sold at a gain are taxed like the underlying stocks or bonds as well. ETFs held for more than a year are taxed at the long-term capital gains rates—up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners.* Equity and bond ETFs you hold for less than a year are taxed at the ordinary income rates, which top out at 40.8%.

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. A grantor trust does nothing but hold the metal; it doesn't buy and sell futures contracts or anything else. 

The IRS treats such ETFs the same as an investment in the metal itself, which—for tax purposes—would be considered an investment in collectibles. The maximum long-term capital gains rate on collectibles stands at 31.8% (including the NIIT), which is higher than the 23.8% top capital gains rate you'd pay for an equity ETF. Short-term gains on collectibles are taxed as ordinary income. (Other precious metals ETFs use futures, which involve a different tax treatment as we'll see in the next section.)

This doesn't mean you should avoid precious metals as a tool for diversifying your portfolio. However, you should be aware of the different tax treatment to avoid surprises.

ETFs that invest in commodities other than precious metals—such as oil, corn, or aluminum—do so via futures contracts, primarily because holding the physical object in a vault is impractical.

The use of futures can have a big impact on a 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 report the investor's share of partnership income on Schedule K-1 instead of Form 1099. Some investors are wary of K-1s because they're more complex to handle on a tax return, and the forms tend to arrive late in tax season. Investors may also worry about incurring unrelated business taxable income (UBTI) from their limited partnership investments that could be taxable even within an IRA. (See IRS Publication 598 for more information.)

That said, commodity ETFs overall have a track record of sending K-1s in a timely manner (though usually sometime after most 1099s are available) and not generating UBTI. K-1s are more complex to handle on a tax return than 1099s, but professional tax preparers or well-informed individuals who do their own taxes should be able to handle K-1s correctly.

Another noteworthy tax feature of ETFs that hold commodity futures contracts is the 60/40 rule. This rule, from IRS Publication 550, 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 the investor has 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).

Furthermore, 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. Thus, if the ETF holds some contracts that have appreciated in value, it will have to realize those gains for tax purposes 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 have been launched that 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 ETF's investment in the subsidiary is considered by the IRS 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.

Currency ETFs come in several different forms. Some are structured as open-end funds, also known as '40 Act funds, much like most equity and bond ETFs. Gains from the sale of these funds are taxed just like equity and bond ETFs: up to the 23.8% long-term rate or the 40.8% short-term rate. 

Other currency ETFs are structured as grantor trusts. Gains from selling these funds are always treated as ordinary income (currently up to the 40.8% rate).

Currency ETFs structured as limited partnerships are taxed just like commodity limited partnerships—with K-1 statements and 60/40 long-term/short-term capital gains treatment.

The bottom line with currency ETFs is that you should read a fund's prospectus to see how the particular ETF will be taxed.

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. They also have their own tax treatment.

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 still could be subject to short- or long-term capital gains tax. 

Equity and bond ETNs work pretty much the same as their ETF equivalents, with long-term gains taxed up to 23.8% and short-term gains taxed as ordinary income. Commodity ETNs are similar.

Currency ETNs are slightly different. The IRS has ruled that gains from selling currency ETNs are to be taxed as ordinary income at up to 40.8%, even if held for the long term, as if the ETN were a currency ETF structured as a grantor trust. 

The table below gives a quick recap of tax rates for the various ETFs and ETNs we discussed:

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.