Because ETFs are structured and traded differently than mutual funds, ETFs typically realize fewer capital gains, making them one of the more tax-efficient investments you can own.
If you invest in ETFs that generate significant income from payouts, however, taxes might be of greater concern. “Dividends and interest are treated differently and should therefore be a factor when selecting funds for your portfolio,” says Emily Doak, CFA and managing director of ETF research at Charles Schwab Investment Advisory.
For example, most dividends from ETFs holding U.S. stocks are considered “qualified” for federal tax purposes, meaning they’re taxed at the long-term capital gains rate of 0%, 15%, or 20%, depending on your income.1 (By contrast, nonqualified dividends are treated as ordinary income, meaning they could be taxed as much as 37% for high-income earners.) But to qualify for the long-term capital gains rate, you must meet certain holding period requirements; if you don’t, your dividends will be subject to ordinary income tax rates.2
Interest payouts from taxable bond ETFs, on the other hand, are always taxed as ordinary income, irrespective of how long you’ve held the fund. So, if generating tax-efficient income is one of your goals, you might instead want to consider municipal bond ETFs, which are tax-free at the federal level (and sometimes at the state level, depending on where you reside).
Of course, taxes are only one consideration among many when selecting investments for your portfolio. Regardless of how their payouts are taxed, funds also need to support your investment goals or income needs. Fortunately, ETFs remain one of the most tax-efficient ways to reach your long-term objectives.
1An additional 3.8% surtax may apply for high-income earners with significant investment income. | 2Payments from securities-lending revenue and income from options strategies are not eligible for qualified tax treatment. For more details, see IRS Publication 550, “Investment Income and Expenses."