ETFs | October 27, 2020

ETFs and Taxes: What You Need to Know

Key Points

  • Stock and bond ETFs are taxed just as the underlying stocks or bonds would be.

  • Precious metals ETFs are currently taxed as collectibles.

  • Commodity and currency ETFs have varying tax treatments.

Exchange-traded funds (ETFs) have a well-deserved reputation for tax efficiency, but a close look at how the tax code treats the various types of ETF in the market 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. It might save you some money at tax time.


How are ETFs taxed in 2020?

Type of ETF or ETN

Tax treatment on gains1

Stock or bond ETF 

Long-term: up to 23.8% maximum2

Short-term: up to 40.8% maximum

Precious metal ETF

Long-term: up to 31.8% maximum

Short-term: up to 40.8% maximum

Commodity ETF (limited partnership)

up to 30.6% maximum regardless of holding period

(Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate)

Currency ETF (open-end fund)

Long-term: up to 23.8% maximum2

Short-term: up to 40.8% maximum

Currency ETF (grantor trust)

Ordinary income (up to 40.8% maximum) regardless of holding period

Currency ETF (limited partnership)

up to 30.6% maximum regardless of holding period

(Note: This is a blended rate that is 60% maximum long-term rate and 40% maximum short-term rate)

Stock or bond ETN

Long-term: up to 23.8% maximum2

Short-term: up to 40.8% maximum

Commodity ETN

Long-term: up to 23.8% maximum2

Short-term: up to 40.8% maximum

Currency ETN

Ordinary income (up to 40.8% maximum) regardless of holding period

Source: irs.gov.

1Note: These rates include the 3.8% Net Investment Income Tax that is applied to investment income if your overall modified adjusted gross income (MAGI) is above certain income thresholds. This is often referred to as the “Medicare surtax” and is layered on top of the other income tax rate you owe on that income.
2Up to a 20% tax rate on net capital gains applies to the extent that a taxpayer’s taxable income exceeds $441,450 for single filers; $496,600 for married filing jointly or qualifying widow(er); $469,050 for head of household; and $248,300 for married filing separately.

Tax efficiency of stock and bond ETFs

ETFs owe their reputation for tax efficiency primarily to stock ETFs, which are generally more tax-efficient than stock mutual funds because ETFs tend not to distribute a lot of capital gains. This is in large part because index-tracking ETFs don’t make many trades. ETF managers also have options for reducing capital gains when creating or redeeming ETF shares.

Remember though, that ETFs holding stocks that pay dividends will ultimately distribute those dividends to shareholders (usually once a year; though 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).

Dividends and interest payments from ETFs are taxed 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% (which includes the 3.8% Net Investment Income Tax), while those held for less than a year are taxed at the ordinary income rates, which top out at 40.8%.

Precious metals ETFs: collectibles tax rate

Investors using ETFs to gain exposure to precious metals such as silver and gold may face a different set of tax issues. For example, 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 investment in a precious metals ETF 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%, which is higher than the 23.8% top capital gains rate you’d pay for a stock ETF. Short-term gains are taxed as ordinary income.

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.

Other commodity ETFs: K-1s and the 60/40 rule

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 futures contracts are more or less expensive than the market price of the commodity. In addition, futures come with tax implications.

ETFs that use futures are structured as limited partnerships and report the share of partnership income flowing to shareholders 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. Some investors may also worry about incurring Unrelated Business Taxable Income (UBTI) from their limited partnership investments that could be taxable even within an IRA.

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 indeed 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.

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).

Currency ETFs

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

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

There are also currency ETFs structured as limited partnerships, which 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.

Exchange Traded Notes (ETNs)

We often caution investors to carefully consider credit risk before investing in exchange-traded notes (ETNs). Instead of being backed by a portfolio of securities independent from the assets of an ETF manager, ETNs are bonds backed by the credit of the issuer. Thus, if the issuer is unable to pay back the ETN shareholders, the shareholders will lose money. That said, it's worth noting that ETNs have their own tax situations. 

Because ETNs don’t hold securities of the underlying index, they generally don't distribute dividends or interests. However, when you sell an ETN, you could be subject to short- or long-term capital gains tax. 

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

Commodity ETNs are generally taxed much like stock and bond ETNs, with long-term gains taxed at up to 23.8% and the ordinary federal rate of up to 40.8% applying to short-term gains.

The true oddball here is the currency ETN; similar to a currency ETF structured as a grantor trust, 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. 

What does it all mean?

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 investment in a tax deferred account, you generally won’t be taxed until you make a withdrawal and when you do withdraw the money you’ll be taxed at your ordinary income tax rates.

If you invest in stocks and bonds via ETFs, you probably won’t be in for many surprises. If you invest in commodities and currencies, things are certainly more complicated. As more exotic ETFs come to market, it’s possible we’ll see new tax treatments, and no tax law is ever set in stone. Be sure to consult with your tax professional for any questions about the taxation of ETFs.

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