Scott Burns: Your Tax ETF Questions Answered. Hi there, I'm Scott Burns, director of ETF Analysis with Morningstar. Today we're going to talk about some of the nuances of taxation issues in the ETF market.
Now, generally, ETFs are known for their tax efficiency, and that is that they have a creation-redemption process that really keeps them from having shadow capital gains distributions like you see in mutual funds. But, that's not the end of the story.
For most ETFs, when we think about ETFs that own a stock, or a bond, or even commodities, the general rule of thumb is that the IRS is going to look through the ETF structure and tax the fund just like it would tax the underlie.
So, if you look at an ETF like the SPDRs, which tracks the S&P 500, that owns 500 stocks, and it will be taxed as if you own those 500 stocks. So, any dividends you receive from that will be taxed as stock dividends, and any capital gains, long-term or short-term, you incur will be taxed as long-term or short-term capital gains.Read Full Transcript
Now, when we think about fixed-income ETFs, the rules still apply. The IRS will look through the structure, take a look at it and say, "This is a basket of bonds."
So, any income that you receive, any income distributions that you receive from the ETF, will be taxed like ordinary income just as income received from a bond would. And any sales for gains or losses that you make on the fund, whether short-term or long-term, will be taxed similarly, the same way as if you had owned the bonds directly.
Now, things get a little more complicated when we start talking about derivative-linked exchange-traded products.
So, many of the commodity ETFs out there, such as the PowerShares Deutsche Bank Commodity Index or the PowerShares Deutsche Bank Agriculture Index--two very popular funds out there--those funds own commodity forwards, futures, and swaps. The rule still applies. The IRS looks through that, and taxes them as if they would tax futures, forwards, and swaps.
So, the issue to keep in mind is that futures, forwards, and swaps are actually not very tax-efficient when you compare them to equities or fixed income. They're generally taxed at a 60/40 rule, which is 60% long-term gains and 40% short-term gains no matter how long you hold the fund.
So, please keep that in mind at the end of the year. In fact, you'll actually have to mark your holdings to market for tax purposes at the end of the year, whether or not you sold the fund. So, don't be surprised.
The other issue you should know about these exchange-traded commodity products is that they're actually not 40 act funds. They're generally structured as limited partnerships. As a result, you'll receive a K-1 form in the mail. But don't be alarmed. These funds do not have any unqualified income in them, so they won't trigger any of the penalties if you hold them in a tax-deferred account.
When we look at our leveraged ETF products out there, these also have a similar issue in terms that they hold futures, forwards, and swaps--basically, derivatives. These funds also turn over their portfolios every day. In general, these funds are not as tax-efficient as a standard stock portfolio.
So if you own a leveraged product you will a) have to mark your book to market at the end of the year, and b) you'll probably have mostly short-term gains no matter how long you held the fund. Again, with leveraged products, we generally recommend keeping the holding period shortly and always watching and maintaining vigilance over the product in your portfolio, in terms of whether or not it needs to be rebalanced.
When we look at the very popular precious metal ETFs out there such as SPDR Gold with the ticker GLD, these products are taxed as collectibles. So again, the IRS looks through the products as what's underneath. The SPDR Gold actually holds gold bars.
Gold bars, silver, and other precious metals are taxed as collectibles by the IRS. That means they're taxed as ordinary income. Any gains or losses are in there with a cap of 28%. So, don't be surprised if you sell it and you don't get short-term capital gains as you might expect.
So, when you take a look at ETFs, it's important not to make general assumptions about the taxation across the different products. Each of these products has very nuanced tax rules that are going to become important to pay attention to come time for your tax planning.
I'm Scott Burns with Morningstar and thanks for watching. For this and other ETF tools, data and research, please check out the ETF Center on Morningstar.com and Morningstar's ETFInvestor Newsletter.