Navigating the Tax Angles for ETFs

Exchange traded funds (ETFs) are hot. Last year, $507.4 billion flowed into ETFs listed in the United States, according to Statista, a provider of market and consumer data. Net assets held by ETFs totaled roughly $5.4 trillion in 2020—up from less than $1 trillion a decade earlier. The trend has apparently continued with a bevy of new ETFs launched in 2021.

While there's no doubt that ETFs are popular, what are the federal income tax angles when you buy and sell ETF shares using a taxable brokerage firm account? Here are the answers.

The Basics

ETFs are similar in some ways to mutual funds. But there are some differences that largely favor ETFs.

Similarities. Like mutual funds, ETFs provide an easy way to invest in portfolios that track the performance of specific stock indexes, industries or geographic sectors. They give you the opportunity to buy or sell an entire portfolio in a single transaction. In addition, both ETFs and mutual funds employ professional managers to meet defined investment objectives, such as current income or capital appreciation.

Key differences. Unlike mutual funds, ETF shares aren't bought directly from the fund or sold back to the fund when they're redeemed. Instead, you buy or sell ETF shares on the applicable stock exchange in the same way that you buy or sell publicly traded stocks. Therefore, the buying and selling strategies that are available for stocks—for example, market orders, limit orders, stop orders and buying on margin—are available for ETFs. In contrast, you can't buy mutual fund shares on margin or sell them short.

Unlike shares in open-end mutual funds that can be redeemed only after the end of the trading day, ETFs are priced throughout the day. They can be bought or sold at any time during the day similar to publicly traded stocks. In addition, the expense ratios for ETFs are often lower than those for open-end mutual funds.

Federal Income Tax Treatment of ETF Dividends

ETFs that hold dividend-paying stocks pay out those dividends, often quarterly. Dividends designated by an ETF as "qualified" dividends are taxed at the same federal rates as net long-term capital gains. Those rates are currently 0%, 15% or 20% depending on your income level.  

Dividends designated by the ETF as "nonqualified" dividends are taxed at higher ordinary income rates. The maximum federal ordinary income tax rate is currently 37%. Plus, at higher income levels, both qualified and nonqualified dividends can be hit with the 3.8% net investment income tax (NIIT) on top of the regular federal income tax hit.

Important: It's possible that Congress will increase some federal tax rates for individuals. If so, 2021 rates will probably be unaffected, but 2022 rates could go up for some taxpayers. We'll keep you up to date on any changes.

Tax Treatment of ETF Capital Gains

If you hold ETF shares in a taxable account for a year or less and sell for a profit, you have a short-term capital gain. Net short-term capital gains recognized by individual taxpayers are taxed at higher ordinary income rates.   

Conversely, if you hold ETF shares in a taxable account for more than a year and sell for a profit, the lower federal income tax rates for net long-term capital gains apply. For individuals with a modest income, the current rate for long-term capital gains is 0%. Most individual taxpayers pay 15% on long-term capital gains, and really high-income people pay the maximum 20% rate. Higher-income people may also owe the 3.8% NIIT. This can raise the current effective federal rate to 18.8% (15% + 3.8%) or to the maximum 23.8% (20% + 3.8%).

However, different rules apply to long-term capital gains from selling precious metal ETFs. (See "Tax Disadvantage for Precious Metal ETFs," below.)

Important: It's possible that Congress will change long-term capital gain rates. If so, 2021 rates will probably be unaffected, but 2022 rates could go up for some taxpayers. 

Tax Treatment of ETF Losses

An individual taxpayer's losses from selling ETF shares held in a taxable brokerage firm account are treated as capital losses. You can deduct capital losses against:

• Capital gains from other sources, and/or
• Up to $3,000 of ordinary income ($1,500 if you used married filing separate status).

Any remaining net capital losses are carried forward to the following tax year and are subject to the same treatment in that year.

Big Tax Advantage over Mutual Funds

Mutual funds must sell securities to cover shareholder redemptions. Selling appreciated securities can trigger capital gains, which are then distributed to continuing shareholders with the resulting income tax increment. Capital gain distributions can occur even during periods when the value of the mutual fund shares themselves are going down. That can result in the worst-case scenario of additional tax liabilities being created while fund share values are dropping. 

In contrast, ETFs don't have to sell their holdings when investors unload their shares. Similar to publicly traded stocks, ETFs are usually just sold to the next investor in line. So, when ETF shareholders bail out, there are no tax consequences for the continuing shareholders. The tax consequences only occur when you sell your ETF shares or when the ETF pays you a dividend.

Tax Disadvantage for Precious Metal ETFs

Some exchange traded funds (ETFs) are a way to invest in precious metals, such as silver, gold, platinum and palladium. These ETFs are attractive to investors who like the idea of owning a stake in precious metal assets but are uncomfortable with the idea of direct physical ownership—where you have to worry about things like transfers and storage.

Precious metal ETFs that are backed solely by physical precious metal assets—as opposed to futures contracts or stock in mining companies—are structured as grantor trusts. For federal income tax purposes, investors in these ETFs are treated as directly owning a share of the fund's precious metal assets.

Most of the tax rules that apply to gains and losses from selling run-of-the-mill ETFs also apply to precious metal ETFs. But there's one critical exception: The IRS has ruled that long-term capital gains recognized by an individual taxpayer from selling shares of precious metal ETFs organized as grantor trusts are taxed the same as long-term gains from selling collectibles. So, an individual taxpayer's long-term capital gains from selling these ETF shares are currently subject to a maximum federal income tax rate of 28% instead of the standard 20% maximum rate.

The 3.8% NIIT can also apply to higher-income individuals. That can raise the current maximum effective federal rate on long-term gains from selling precious metal ETF shares to 31.8% (28% + 3.8%). Therefore, compared to mutual funds and stocks, precious metal ETFs organized as grantor trusts suffer from a federal income tax disadvantage due to the 28% maximum rate on long-term gains.

We Can Help

The tax rules for ETF shares held in taxable brokerage firm accounts can be tricky. If you have questions or want more information, contact your SSB tax advisor.