
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 ETFs and taxes, read on about the ins and outs of capital gains distributions, dividends, interest, K-1 statements, collectibles tax rates, and more. 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 thousands. Although similar to mutual funds, equity ETFs are generally more tax-efficient because ETF managers have the ability to reduce capital gains when creating or redeeming ETF shares.
This is in large part because many ETFs passively track the performance of an index, meaning they typically rebalance their holdings only when the underlying index changes its constituent stocks. Such adjustments don't trigger immediate taxable gains distributions to shareholders, whereas with mutual funds, which are more likely to be actively managed, shareholders will owe long-term capital gains tax on any distributions—even if they are unpaid.
That said, ETFs that hold dividend-paying stocks must distribute earnings to shareholders usually once a year¬, but dividend-focused ETFs may do so more frequently. At the federal level, ordinary, or nonqualified, dividends are taxed at the ordinary income rate up to 37%. Qualified dividends—which must meet certain conditions set by the IRS and are subject to a holding period—may be taxed at the lower federal long-term capital gains rates of 0%, 15%, or 20%, depending on your income. Interest distributed to shareholders by bond ETFs—monthly, in many cases—is also taxed as ordinary income. Be aware that you may owe state taxes on your earnings as well.
If you sell an equity or bond ETF, any gains will be taxed based on how long you owned it and your annual income. You'll be taxed at the short-term capital gains rate, which is the same as your ordinary income rate, for ETFs you've held for one year or less, and you'll pay long-term capital gains taxes for ETFs owned more than a year. High earners with investment income (taxpayers with an income threshold of $200,000 for single filers and $250,000 for married filing jointly) could face an additional 3.8% net investment income tax (NIIT) on their gains.
Futures-based ETFs: K-1s and the 60/40 rule
ETFs that invest in commodities like oil, corn, or aluminum and certain cryptocurrency ETFs—such as bitcoin or ether futures ETFs—do so via futures contracts, which come with their own tax implications.
Futures can have a big impact on your portfolio's returns because of contango and backwardation—that is, whether the included futures contracts tend to be more expensive than the market price (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).
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, if you hold the ETF within a tax advantaged account, like a traditional IRA. (See IRS Publication 598 for more information.)
Another noteworthy tax feature of futures-based ETFs is the 60/40 rule, which states that any gains or capital losses realized by selling these types of investments are treated as 60% long-term gains (up to 20% tax rate) and 40% short-term gains (up to 37% tax rate). This happens regardless of how long you've held the ETF.
The blended rate could be a tax 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 28%, and short-term gains are taxed as ordinary income.
ETFs not structured as a trust backed by the precious metal often invest in futures contracts and are treated like a futures-based ETF, so be aware of the type of precious metals ETF you hold to avoid surprises on your tax bill.
Currency ETFs and cryptocurrency exchange-traded products (ETPs)
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 20% long-term capital gains rate or the 37% short-term rate when sold.
Gains from selling currency ETFs structured as grantor trusts are always treated as ordinary income (currently up to the 37% rate ) while those investing in futures contracts and structured as limited partnerships are taxed using the 60/40 rule. However, cryptocurrency exchange-traded products (ETPs) that are structured as grantor trusts and track the spot price of a cryptocurrency are taxed as property and subject to capital gains tax rules.
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, ETNs, and ETPs generally taxed?
Type of ETF or ETN | Tax treatment on gains |
---|---|
Equity or bond ETF |
|
Precious metal ETF |
|
Futures-based ETF (limited partnership) | Up to 26.8%, regardless of holding period (Note: This is a blended rate that is 60% long-term rate and 40% short-term rate) |
Commodity ETF (open-end fund) |
|
Currency ETF (open-end fund) |
|
Currency ETF (grantor trust) | Ordinary income (up to 37%), regardless of holding period |
Currency ETF (limited partnership) | Up to 26.830.6% maximum, regardless of holding period (Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate) |
Cryptocurrency ETP (grantor trust) |
|
Equity or bond ETN |
|
Commodity ETN |
|
Source:
irs.gov.
Tax rates do not include state taxes. High earners may also be subject to an additional 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 table is for educational purposes and general informational purposes only and is not intended to be a substitute for specific tax advice or an interpretation of tax laws. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor and refer to the IRS website at irs.gov to determine the tax consequences of an investment.
Bottom line on ETFs and taxes
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 a traditional 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 ordinary income tax rate at the time.
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.
Considering ETFs for your portfolio?
All ETFs are subject to management fees and expenses.
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 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.
Cryptocurrency-related products carry a substantial level of risk and are not suitable for all investors. Investments in cryptocurrencies are relatively new, highly speculative, and may be subject to extreme price volatility, illiquidity, and increased risk of loss, including your entire investment in the fund. Spot markets on which cryptocurrencies trade are relatively new and largely unregulated, and therefore, may be more exposed to fraud and security breaches than established, regulated exchanges for other financial assets or instruments. Some cryptocurrency-related products use futures contracts to attempt to duplicate the performance of an investment in cryptocurrency, which may result in unpredictable pricing, higher transaction costs, and performance that fails to track the price of the reference cryptocurrency as intended. Please read more about risks of trading cryptocurrency futures here.
Virtual Currency Derivatives trading involves unique and significant risks. Please read NFA Investor Advisory – Futures on Virtual Currencies Including Bitcoin and CFTC Customer Advisory: Understand the Risk of Virtual Currency Trading.
Charles Schwab Futures and Forex LLC is a member of NFA and is subject to NFA's regulatory oversight and examinations. However, you should be aware that NFA does not have regulatory oversight authority over underlying or spot virtual currency products or transactions or virtual currency exchanges, custodians, or markets.
You should carefully consider whether trading in virtual currency derivatives is appropriate for you in light of your experience, objectives, financial resources, and other relevant circumstances.
Please note that virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Virtual currencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not currently backed nor supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional fiat currencies. Profits and losses related to this volatility are amplified in margined.
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.
Investing involves risk, including loss of principal.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.
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. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV).
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.