What is the tax treatment for ETFs?
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold. Internal Revenue Service.
ETFs are treated the same as conventional open-end mutual funds for tax purposes. Investors generally pay taxes on income and capital gains distributions during the life of the investment, as well as on any capital gains generated on the sale of their ETF units.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
If you're investing in a taxable brokerage account, you may be able to squeeze out a bit more tax efficiency from an ETF than an index fund. However, index funds are still very tax-efficient, so the difference is negligible. Don't sell an index fund just to buy the equivalent ETF.
One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.
ETFs are built to avoid the capital gains that result from turnover and redemptions. Investors buy or sell ETF shares on a stock exchange from other investors, not the fund. This avoids the need to raise cash to meet redemptions for small investors.
ETF capital gains taxes
Of course, investors who realize a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%.
If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Has an ETF ever gone to zero?
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.
Vanguard is paid by the funds to provide administration and other services. If Vanguard ever did go bankrupt, the funds would not be affected and would simply hire another firm to provide these services.
Not all ETF dividends are taxed the same; they are broken down into qualified and unqualified dividends. Qualified dividends are taxed between 0% and 20%. Unqualified dividends are taxed from 10% to 37%. High earners pay additional tax on dividends, but only if they make a substantial income.
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.
Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
Unlike mutual funds, however, ETFs are traded on the open market like stocks and bonds. While mutual fund shareholders can only redeem shares with the fund directly, ETF shareholders can buy and sell shares of an ETF at any time, completely at their discretion.
Just like mutual funds, ETFs distribute capital gains (usually in December each year) and dividends (monthly or quarterly, depending on the ETF). Even though capital gains for index ETFs are rare, you may face capital gains taxes even if you haven't sold any shares.
What is the capital gains discount for ETF?
If you've owned an ETF for 12 months, the law allows the taxable capital gain to be reduced by 50% for individuals. This means that tax is only paid on half of the capital gain.
You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all. Consider the two funds below.
That's because mutual funds must distribute any dividends and net realized capital gains earned on their holdings over the prior 12 months. For investors with taxable accounts, these distributions are taxable income, even if the money is reinvested in additional fund shares and they have not sold any shares.
ETF trading generally occurs in-kind, meaning they are not redeemed for cash. Mutual fund shares can be redeemed for money at the fund's net asset value for that day. Stocks are bought and sold using cash.
For investors who like the convenience and built-in diversification of a mutual fund, equity exchange-traded funds can make fine, tax-efficient options for taxable accounts. Most ETFs track indexes, so their turnover is often very low, meaning that capital gains distributions also tend to be few and far between.
