Exchange-traded funds (ETFs) are popular. Very popular.
Wow! That’s probably enough to cover Jeff Bezos’s expenses for at least a couple years — not counting trips into space. The trend is apparently continuing with a bunch of new ETFs being launched this year.
But what about the tax angles for ETFs? Good question. Let’s get to them after first reviewing the basics. Here goes:
Buy or sell an entire portfolio in a single transaction
In some ways, ETFs are similar to mutual funds, but they also have differences — most of which are beneficial. Like mutual funds, ETFs offer investors an easy way to invest in portfolios that track the performance of specific stock indexes, industries, or geographic sectors. As such, they give investors the opportunity to buy or sell an entire portfolio in a single transaction.
Like mutual funds, ETFs hire professional managers to meet defined investment objectives, such as current income or capital appreciation.
Unlike mutual funds, individual investors don’t buy or redeem ETF shares directly from the fund. Instead, they buy or sell ETF shares on the applicable stock exchange in the same way that stocks are bought and sold. Therefore, all the buying and selling strategies available for stocks (market orders, limit orders, stop orders, and buying on margin) are also available for ETFs.
No sales loads
There are no load charges, but brokerage-firm commissions may apply to the purchase or sale of ETF shares.
You can buy or sell any time during trading day
Unlike open-end mutual funds that can only be redeemed at the end of the trading day, ETFs are priced throughout the day and can be bought or sold at any time during the day just like stocks.
You can buy on margin
Not possible with mutual funds.
You can sell short
Not possible with mutual funds.
Reasonable management fees
Expense ratios for ETFs are often lower than those for open-end mutual funds. Annual expense charges usually range between .15% and 1.0% of the value of the fund, but a ratio of about .25% is the norm.
Instant exposure to diversified portfolios
You can buy ETFs that represent broad-based market indexes and specific industry or geographic sectors.
Tax treatment of ETF dividends
ETFs that hold dividend-paying stocks pay out those dividends, often quarterly. Dividends designated by an ETF as qualified dividends are taxed at the same federal rates as net long-term capital gains: currently 0%, 15%, or 20% depending on your income level.
Warning: The proposed Biden tax plan would increase the maximum federal rate on qualified dividends to 39.6% for dividends received after April of this year. After tacking on the 3.8% net investment income tax (NIIT), the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%).
However, the proposed rate increase would only apply to taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000 if you use married filing separate status.
Dividends designated by the ETF as nonqualified dividends are taxed at higher ordinary income rates. While qualified dividends from an ETF are taxed at the same federal rates as long-term capital gains, you cannot offset them with capital losses. At higher income levels, nonqualified dividends can be hit with the 3.8% NIIT on top of the “regular” federal income tax hit.
Warning: Starting in 2022, the proposed Biden tax plan would raise the top individual federal income-tax rate on non-qualified dividends back to 39.6%, the top rate that was in effect before the Tax Cuts and Jobs Act lowered it to the current 37%. This proposed rate increase would affect singles with taxable income above $452,700, married joint-filing couples with taxable income above $509,300, and head of households with taxable income above $481,000. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%).
Tax treatment of ETF short-term gains
If you hold garden-variety ETF shares in a taxable account for one year or less and sell for a profit, you have a short-term capital gain. Net short-term capital gains are taxed at higher ordinary income rates — just like salary and interest income.
Warning: Starting in 2022, the proposed Biden tax plan would raise the top federal income-tax rate on net short-term capital gains recognized by individuals back to 39.6%, the top rate that was in effect before the Tax Cuts and Jobs Act lowered it to the current 37%. This proposed rate increase would affect singles with taxable income above $452,700, married joint-filing couples with taxable income above $509,300, and head of households with taxable income above $481,000. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%).
Tax treatment of ETF long-term gains
If you hold garden-variety ETF shares in a taxable account for more than one year and sell for a profit, the lower federal long-term capital gains tax rates for individuals apply. If you have a modest income, the current rate is 0%. Most folks pay 15%, and really high-income folks pay the maximum 20% rate. Higher-income folks may also owe the 3.8% NIIT, which can raise the current effective federal rate to 18.8% (15% + 3.8%) or 23.8% (20% + 3.8%).
Warning: The proposed Biden tax plan would increase the maximum federal rate on net long-term capital gains to 39.6% for gains recognized after some magic date in April of this year. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%). Ouch! However, the proposed rate increase would only apply to taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000 if married filing separate status is used. You would be subject to the higher maximum rate only to the extent your AGI exceeds the applicable threshold. For example, a married joint-filing couple with AGI of $1.2 million, including a $300,000 net long-term capital gain, would apparently pay the 39.6%/43.4% maximum rate only on the last $200,000 of net long-term capital gain. Will this proposed retroactive near-doubling of the maximum effective federal rate on long-term gains get through a closely divided Congress? We shall see.
Tax treatment of ETF losses
Losses from selling garden-variety ETF shares are treated as capital losses. You can deduct capital losses against: (1) capital gains from other sources and/or (2) up to $3,000 of ordinary income from salary, self-employment, interest, and so forth ($1,500 if you used married filing separate status). Any remaining capital losses are carried forward to the following tax year and are subject to the same rules in that year.
One big ETF tax advantage over mutual funds
Mutual funds must sell securities to cover shareholder redemptions. Selling appreciated securities can trigger capital gains, which are then distributed to continuing shareholders with the resulting tax bill. Capital gain distributions can occur even during periods when the value of the fund shares themselves are going down. That results in the worst-case scenario of tax bills coming due while shares values are dropping. Yuck!
In contrast, ETFs don’t have to sell assets to cover redemptions, because there are no redemptions. When ETF investors unload their shares, they are simply sold to the next investor in line — like stocks. So, when ETF shareholders bail out, there are no tax consequences for the continuing shareholders. The tax consequences only occur when you actually sell your ETF shares or when the ETF pays you a dividend.
The bottom line
You now understand the federal income tax rules that apply to garden-variety ETF shares. However, special rules apply to precious metal and commodity ETFs. I’ll cover those special rules in my next column. Please stay tuned.
Related: Here are the ETFs to help you invest in the Biden infrastructure plan