How ETF Dividends Are Taxed

Exchange-traded funds (ETFs) are popular investments that operate just like mutual funds. ETFs are a type of basket of securities that track an underlying asset, such as an index, currency, or commodity. They trade just like stocks so investors can buy and sell shares on stock exchanges.

If you're interested in investing in ETFs, it's important for you to understand just how they work, including any tax implications that may apply. The tax treatment of these investments is similar to that of the underlying asset:

• You're taxed for an ETF composed of stocks in the same way as the sale of those stocks.
• If you hold an ETF for more than a year and net a profit on the sale, you will pay capital gains tax.
• If you hold it for less than one year, any profits are treated as ordinary income.

Although the required taxes are usually similar, there are extenuating circumstances for certain types of ETFs and their dividends, provided they meet certain criteria.

Qualified vs. Unqualified Dividends

Qualified dividends are dividends that are taxed at a lower capital gains tax rate than unqualified or ordinary dividends. Depending on the investor's tax bracket, qualified dividends can be taxed anywhere from 0% to 20%.

The lower capital gains tax rate that is applied to qualified dividends comes as a result of that dividend meeting special requirements put in place by the Internal Revenue Service (IRS). The following are the requirements under IRS rules:

• The dividend must be paid by a U.S. company or a qualifying foreign company.
• The dividends weren't previously excluded by the IRS as qualified dividends.
• The holding period is met.

Unqualified dividends are those that are taxed at the federal income tax rate. This can range anywhere from 10% to 37% for the 2022 tax year. Most dividends fall into this category as they are considered unqualified by default. They only become qualified if the above criteria are pursued and met.

ETF Dividend Taxation

Let’s first establish that the holding stocks of ETFs usually pay dividends quarterly or once a year, and ETFs holding bonds usually pay interest every month. If you’re investing in an ETF that holds stocks, then make sure it pays qualified dividends.

Qualified

To receive a qualified dividend, you must hold an ETF for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date and ends 60 days after that date. This is the last day when new owners can qualify for the next dividend.

The current tax rates on qualified dividends are 0%, 15%, and 20%, depending on your filing status and tax bracket. However, if you hold the stock for fewer than 60 days during that 121-day period, the dividends are not taxed as qualified dividends.

You could pay 0% taxes on qualified ETF dividends if you are in one of the lower tax brackets. Granted, you would still pay tax when you sold the ETF itself, but would not pay taxes as long as you satisfy the qualified dividend requirements for holding mentioned above.

For single taxpayers, this threshold is $41,675 for 2022 and $44,625 for 2023. As long as your modified adjusted gross income (MAGI) is below this level, you would pay no taxes on qualified dividends. The next dividend rate is 15% for incomes between $41,675 and $459,750 for 2022 and $44,625 and $492,300 for 2023. Individuals who make more will pay a 20% tax on their qualified dividends.

Unqualified

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. Of course, this only applies to the dividend. All sales of an ETF under one year will result in a short-term capital gains tax, which is significantly higher than the tax you would pay if you would have held it for a year or more.

Individuals who are in the highest tax brackets will be required to pay an additional 3.8% net investment income tax (NIIT). For single filers, this threshold is $200,000. Married filing jointly is $250,000, and filing separately is $150,000. The income amounts that trigger the NIIT are based on the filing person's MAGI.

Dividend ETFs

Some investors find that having dividend-paying ETFs can add a solid core to their portfolios. It can offer tax advantages as well as provide a steady stream of income in the form of qualified dividends. Let's take a look at two dividend-paying ETFs: The SPDR Portfolio S&P 500 High Dividend ETF (SPYD) and the Schwab U.S. Dividend Equity ETF (SCHD).

SPYD is one of the larger high-dividend ETFs on the market today. It aims to track the High Dividend Index of the S&P 500. This index measures the 80 highest-dividend-yielding companies in the index. The ETF pays a healthy dividend which is derived from mostly large-cap stocks in financials, utilities, and real estate.

SCHD tracks the total return of the Dow Jones U.S. Dividend 100 Index. It is similar to SPYD above as it is a relatively straightforward, low-cost ETF designed to offer investors broad exposure while providing a quarterly dividend payment. Out of 103 names, this ETF's top three holdings are Merck, Amgen, and IBM. The ETF is heavy in IT, financials, and consumer staples.

The Bottom Line

Tax obligations for ETF dividends depend on whether or not they’re classified as qualified or unqualified. If they’re unqualified, they will be taxed at your normal income rate. Qualified dividends, on the other hand, are taxed between 0% and 20%. Discussing an ETF dividend strategy is best done with a qualified investment advisor and accountant if you are not clear on the complexities involving your income and tax brackets.

Correction—Aug. 13, 2022: This article has been updated to clarify the rules surrounding the holding period for qualified dividends and to make clear who is eligible for those dividends.