Exchange traded funds (ETFs) are uniquely structured investments that track indexes, commodities or baskets of assets. Like stocks, ETFs can be purchased on margin and sold short, and prices fluctuate throughout each trading session as shares are bought and sold on various exchanges. Twenty years ago, the first exchange traded fund (ETF) was introduced - the SPDR S&P 500 ETF (SPY). Since then, the ETF industry has blossomed into a trillion-dollar-a-year business, with an increasing number of ETFs available to match a variety of investment styles, goals and risk tolerances.
ETFs have become standard in many investors' portfolios, due in part to the many benefits of ETF investing, including their tax efficiency. Due to the method by which ETFs are created and redeemed, investors are able to delay paying most capital gains until an ETF is sold. As with any investment, it is important for investors to understand the tax implications of ETFs prior to investing. Here we will introduce asset classes, structures and the tax treatment of exchange traded funds.
ETF Asset Class and Structure
The way that an ETF is taxed is determined by its method of gaining exposure to its underlying assets, its structure and the amount of time that the ETF is held.
Exchange traded funds can be categorized into one of five asset classes:
Equity funds (market indexes, stocks)
Fixed income funds (bonds)
Commodity funds (tangible goods)
Currency funds (foreign currency)
Alternative funds (multiple asset classes or nontraditional assets)
For taxation purposes, ETFs are further categorized by one of five fund structures:
Unit investment trusts (UITs)
Limited partnerships (LPs)
Exchange-traded notes (ETNs)
ETF Tax Treatment
The combination of an ETF's asset class and structure, along with how long the ETF is held (short-term gains apply to investments that are held for one year or less; long-term gains apply when a position is held for more than one year), determines its potential tax treatment. Figure 1 shows the maximum long-term and short-term tax rates for various ETF asset classes and structures (your tax rate may differ depending on your marginal tax rate).
Note: Under the new 2013 tax laws, higher-income individuals (those with taxable income above $400,000) and married couples filing jointly (with taxable income above $450,000) will be subject to a 20% maximum long-term capital gains tax rate, and the new 3.8% Medicare surtax on investment income. 2013 also brings an increased tax rate on ordinary income, brining the maximum rates on ordinary income to 39.6% for the higher-income filers.
|Maximum Long-Term/Short-Term Capital Gains % for ETFs|
The table above shows maximum long-term and short-term capital gains rates, by percentage. The maximum rate for both long-term and short-term capital gains for higher-income individuals and married couples may differ under 2013 tax laws.
As the table above illustrates, the maximum tax rates for positions held on a long-term basis range from 15 to 35%. For short-term investments, the rates vary from a maximum of 23 to 35%. Because there is such a broad range of tax rates and potential financial implications, it is important to understand a fund's structure before investing. The SPDR S&P 500 ETF (SPY), for example, holds all of the S&P 500 Index stocks, so it would be categorized as an equity fund. It is structured as a Unit Investment Trust. From Figure 1, we see that an equity fund structured as a UIT would be subject to a maximum 15% long-term/35% short-term tax rate. Information regarding a fund's holdings and structure can typically be found in a fund's quick fact sheet or prospectus.
Currency, Futures and Metals ETFs
Special treatment is given to currency, futures and metals ETFs. In general, ETF tax rules follow the sector in which the ETF invests. Profits earned from currency ETFs structured as grantor trusts, for example, are taxed as ordinary income, regardless of how long the position is held.
Futures ETFs gain exposure to an underlying commodity or asset through investing in futures contracts. Any gains and losses on the futures held by the ETF are treated as 60% long-term and 40% short-term for tax purposes. In addition, mark-to-market rules may apply, and unrealized gains will be taxed as if they had been sold at the end of the year.
Gold, silver and platinum bullion are considered collectibles for tax purposes. If your gain is short term, it will be taxed as ordinary income. If it is long term, it will be taxed at the capital gains rate that is appropriate for your personal tax bracket.
The Bottom Line
Exchange traded funds are an increasingly popular investment choice for those who want take advantage of the many favorable ETF features, including tax efficiency. This article is intended to provide an introduction only. Because tax laws are complicated and do change from time to time, it is important to consult with a qualified tax specialist, such as a Certified Public Accountant (CPA), before making any investment decisions and filing your annual return.