ETFs—exchange-traded funds—are taxed in the same way as its underlying assets would be taxed. Therefore, if an ETF has all stock holdings, it gets taxed just as the sale of those stocks would be taxed.
If you hold an ETF for more than a year, then you will pay capital gains tax. If you hold it for less than one year, any profits will be treated as ordinary income. The only exception is precious metal ETFs. If a precious metal ETF actually holds precious metals, then the ETF will be taxed as a collectible, which means it will be taxed at a maximum 28% rate. However, this is still bad news for most investors.
ETF Qualified Dividends Taxation
Let’s first establish that ETFs holding stocks usually pay dividends once a year, and ETFs holding bonds usually pay interest monthly. If you’re investing in an ETF that holds stocks, then you want to make sure it's paying qualified dividends.
Qualified dividends must be paid by an American company or a qualifying foreign company. They must not be listed as an unqualified dividend with the IRS, and the holding period must have been met.
To receive a qualified dividend, you must hold an ETF for more than 60 days before the dividend is issued. The current tax rates on qualified dividends are 5%, 15%, and 20%, depending on your filing status and tax bracket.
If you hold an ETF for fewer than 60 days, dividends will be taxed as ordinary income. All dividend income will be reported on Form 1099-DIV.
Potentially Safe ETFs With Attractive Yields
No investment is bulletproof. If the stock market holds up as many people expect, then iShares US Preferred Stock (PFF), which tracks the performance of the S&P U.S. Preferred Stock Index, would be an option to consider. As an ETF, the first thing you want to look at is the expense ratio. In this case, it’s 0.46%, which is a little over the average ETF expense ratio of 0.44%. PFF, at the time of this writing, it yields 5.04%.
The same warning above applies to WisdomTree Total Dividend ETF (DTD). This ETF tracks the performance of the WisdomTree Dividend Index and comes with an expense ratio of just 0.28% and a distribution yield of 3.83%.
The Bottom Line
Tax obligations for ETF dividends depend on whether or not they’re qualified or unqualified dividends. If they’re unqualified dividends, they will be taxed at your normal income rate. If they’re qualified dividends, they will be taxed between 5% and 20%. If you’re looking for dividend-paying ETFs to invest in, you can use PFF and DTD as starting points, or do your own research on other ETFs that pay high dividends. (For more, see: 5 Dividend ETFs With Growth Potential).
Dan Moskowitz does not have any positions in PFF or DTD.