Exchange-traded funds (ETFs) have some features of both individual stocks and mutual funds, but are unique investment vehicles. From a tax perspective, here are some basic rules about ETFs you need to know.
Annual distributions from an ETF to investors may be treated as qualified or nonqualified dividends. Qualified dividends are taxed at no more than 15% (zero for investors in the 10% or 15% tax bracket; 20% for those in the 39.6% bracket starting in 2013). However, just because the ETF reports on Form 1099-DIV that its distribution was a qualified dividend does not automatically make it qualified for the investor. The investor must have held the ETF for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.
Like stock, an investor’s basis in ETF shares usually is based on cost—what the investor paid for the shares, plus any sales commissions. (Different rules apply if the investor receives shares by gift or inheritance). Basis is increased by any taxable dividends that are reinvested in additional ETF shares.
Basis may be reported to the IRS and to the investor on Form 1099-B when shares are sold. Certain basis reporting is now mandatory, but it is unclear whether it applies to ETFs acquired in 2011 or not until 2012. Some firms included the basis of ETFs bought and sold in 2011 on the 1099s provided to investors in 2012. Other firms waited until 2013 to start such reporting. However, going forward as firms track ETF purchases, more and more basis information will be made available to the IRS and investors.
Capital gain or loss
When you sell shares in ETFs, you’ll have a capital gain or loss, depending on your basis in the shares. This is no different than the tax treatment that applies to the sale of shares in individual stocks or in mutual funds. With some exceptions for certain types of ETFs, long-term capital gains are taxed at no more than 15% (zero for investors in the 10% or 15% tax bracket; 20% for investors in the 39.6% tax bracket starting in 2013).
Capital losses on the sale of shares in ETFs can be used to offset capital gains and up to $3,000 of ordinary income ($1,500 for married persons filing separately). Capital losses in excess of these limits can be carried forward and used in future years.
Note: In addition to income tax on net gains, there is also a special Medicare tax of 3.8% starting in 2013. It applies to net investment income (including gains from the sale of ETFs); it applies only to high-income investors.
It is repeatedly said that ETFs offer tax efficiency. What does this mean? There are essentially two reasons for this label.
- Marketing timing. Unlike mutual fund shares that can only be bought and sold at the end of the trading day, shares in ETFs can be purchased throughout the trading day like stocks. This allows investors to get in and out of their holding when investment decisions and tax results dictate. What’s more, ETFs also utilize a process called "Create and Redeem" to facilitate investor purchases and sales of the ETF shares. Under Create and Redeem, ETFs (unlike traditional, open-end mutual funds) do not have to sell individual securities in order to meet redemptions; instead can use an Authorized Participant (AP) to act as a tax-smart clearinghouse to facilitate redemptions.
- Distributions. Both mutual funds and ETFs generally are required to distribute capital gains to investors, which can potentially result in a significant tax cost annually. However, because ETFs trade less frequently than mutual funds—for the most part they are indexes that are usually fixed and they do not have to sell off holdings to generate cash for redemptions—there are usually lower taxable capital gains distributions.
A Final Word
To determine the potential tax impact on you of buying, holding, or selling ETFs, talk with your personal tax advisor.