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. To better understand the ins and outs of capital gains distributions, dividends, interest, K-1 statements, collectibles tax rates, and more, read on. You could potentially save money at tax time.

ETFs owe their reputation for tax efficiency primarily to passively managed equity ETFs, which can hold anywhere from a few dozen stocks to more than 9,000. 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 typically rebalance their holdings only when the underlying index changes its constituent stocks—whereas mutual funds are more likely to be 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 earnings to shareholders—usually once a year¬—while dividend-focused ETFs may do so more frequently. Qualified dividends may be taxed at lower capital gains rates if certain conditions are met—otherwise, you'll be taxed at the ordinary income rate, which tops out at 40.8%. Interest distributed to shareholders by bond ETFs—monthly, in many cases—is also taxed as ordinary income.

If you sell an equity or bond ETF, any gains will be taxed based on how long you owned it and your income. For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners.¹ If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

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

Futures can have a big impact on your 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 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, even if you hold the ETF within a traditional IRA. (See IRS Publication 598 for more information.)

Another noteworthy tax feature of commodity ETFs is the 60/40 rule, which 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 you've 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).

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.

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 31.8% (including the NIIT), and short-term gains are taxed as ordinary income.

ETFs not structured as a trust backed by the precious metal are treated like a commodity ETF, so be aware of the type of precious metals ETF you hold to avoid surprises on your tax bill.

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 23.8% long-term rate or the 40.8% short-term rate when sold.

Gains from selling currency ETFs structured as grantor trusts are always treated as ordinary income (currently up to the 40.8% rate) while those structured as limited partnerships are taxed using the 60/40 rule.

With currency ETFs, be sure to read the fund's prospectus to see how it 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.

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.

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.