As December draws to a close, investors are mulling over their taxable investment accounts to assess capital gains for the year. While exchange traded funds are a tax efficient vehicle, investors shouldn't skimp on researching options as there are subtle differences in the tax code for varying structures.
First off, ETFs are generally more tax efficient, compared to mutual funds, because ETFs typically trade less as they try to passively track a benchmark and they utilize "in-kind creation and redemption" to diminish the capital gains tax burden on shareholders.
Stock ETF dividends and fixed-income ETF yields will be distributed to shareholders and are taxed like income from the underlying stocks or bonds through a 1099 statement, writes Michael Iachini CFA, CFP, Managing Director of ETF Research at Charles Schwab Investment Advisory, Inc.
Stock and bond ETFs are taxed at a current 23.8% maximum rate on long-term gains and ordinary, short-term maximum rates are 43.4% - as of 2013, a new Net Investment Income tax tacks on a 3.8% surtax for taxpayers with adjusted gross income surpassing a threshold limit.
Precious metals ETFs, like gold and silver, are structured as grantor trusts and are backed by the physical metal holdings. The IRS treats the investments as if the investor held the hard asset. Consequently, physical metal ETFs are taxed as collectibles with long-term gains at a maximum 31.8% tax rate and short-term gains taxed up to a 43.4% rate.
Commodities ETFs and other funds that utilize futures contracts to gain exposure to the underlying market are structured as limited partnerships. Consequently, investors may have to fill out a Schedule K-1 instead of Form 1099, and they may incur Unrelated Business Taxable Income (UBTI), which could be taxable in an IRA - most ETFs, though, provide K-1s in a timely manner and typically do not generate UBTIs. Futures-backed ETFs are taxed based on the 60/40 rule - 60% long-term gains at a maximum 23.8% rate and 40% short-term gains at a maximum 43.4% rate - regardless of how long the investor holds the ETF. Additionally, at the end of the year, the ETF must "mark to market" all outstanding contracts and treat them as if the fund sold those contracts, and investors would realize those gains for tax purposes.
Currency ETFs come in three structures: 1) Open-end funds, or '40 Act funds, are taxed like stock and bond ETFs at a maximum 23.8% long-term rate and maximum 43.4% short-term rate. 2) Currency ETFs structured as grantor trusts, similar to precious metals ETFs, but gains are always treated as ordinary income at a maximum 43.4% rate. 3) Funds structured as limited partnerships issue K-1 statements and follow the 60/40 long-term/short-term rule.
While trading ETFs, investors may come across exchange traded notes. ETNs are not ETFs. ETNs are a type of bond or debt security issued by an underwriting bank and subject to the credit risk of the issuer. Gains in stock, bond and commodity ETNs are taxed at a maximum long-term 23.8% rate and maximum 43.4% rate. Currency ETNs, though, are taxed as ordinary income at a maximum 43.4% rate.