If you own shares in an exchange-traded fund (ETF), you may receive distributions in the form of dividends. These may be paid monthly or at some other interval, depending on the ETF you own. Not all dividends are treated the same from a tax perspective.
Types of dividends
There are two basic types of dividends issued to investors of ETFs:
- Qualified dividends: These are dividends designated by the ETF as qualified, which means they qualify to be taxed at the capital gains rate, which depends on the investor’s modified adjusted gross income (AGI) and taxable income (the rates are 0%, 15%, 18.8%, and 23.8% for 2014). These dividends are paid on stock held by the ETF. The ETF must own the underlying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. And the investor must own the shares in the ETF paying the dividend for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. If you actively trade ETFs, you probably can’t meet this holding requirement.
- Nonqualified dividends: These are dividends not designated by the ETF as qualified (e.g., they may have been payable on stock held by the ETF for 60 days or less). They are taxed at your ordinary income rates. Basically, nonqualified dividends are the amount of total dividends minus any portion of the total dividends treated as qualified dividends.
Note: While qualified dividends are taxed at the same rate at capital gains, they cannot be used to offset capital losses.
Other ETF distributions
Depending on the type of ETF, other distributions to investors may not be qualified dividends. Here are a couple of examples of other types of distributions from ETFs:
- Fixed income ETFs pay interest, not dividends.
- Real estate investment trust (REIT) ETFs typically pay nonqualified dividends (although a portion may be qualified).
A dividend ETF is made up of dividend-paying stocks; it usually tracks a dividend index. This ETF pays dividends to investors, which can be qualified or nonqualified dividends, as explained earlier.
Reinvesting ETF dividends
You can choose to use your ETF dividends to acquire more shares in the same ETF. However, there may be commissions for reinvesting dividends. Check with the brokerage firm or other financial institution at which you hold ETFs.
The brokerage firm or other financial institution at which you hold ETFs must report annually to the IRS and to you the payment of dividends of $10 or more (some institutions automatically report all dividends). Form 1099-DIV, Dividends and Distributions, is used for this purpose.
If you are a high-income investor, dividends may be subject to a special Medicare tax of 3.8%, in addition to any income tax on the dividends. This tax applies to net investment income and is called the NII tax.
If you receive a substantial amount of dividends from ETFs, you may need to pay quarterly estimated taxes. Work with your tax advisor to assess your estimated tax needs and to be sure that you properly report your ETF dividends on your tax return.