How to Avoid Tax Surprises in ETFs

Jeremy Glaser: How to avoid tax surprises in your ETFs. I'm Jeremy Glaser with Morningstar.com.

ETFs are generally known as very tax-efficient investments, but they can't shield you from underlying investments that aren't particularly tax efficient. I'm here with director of ETF research Scott Burns to elaborate on this.

Scott, thanks for joining me today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So what are some instances in which you buy an ETF and you could be surprised at the tax efficiency of it?

Burns: Right. In general, when most people think about ETFs and the tax efficiency reputation they've got, it's for what we like to call vanilla ETFs. Those are ETFs that own stocks or own bonds, and they're collections of fairly common baskets.

The IRS looks through the ETF structure, and it says, "OK, look, if you own a stock, we're going to tax you like a stock." The creation-redemption mechanism allows you to push off that time. But there are ETFs out there that own a lot of esoteric either financial instruments or physical commodities, et cetera, that are not as tax efficient as those vanilla ETFs. But it's not really a function of the ETF; it's actually a function of the underlying.

Some examples of that would actually be SPDR Gold, which is the second-largest ETF out there and the largest gold ETF out there. Gold is actually taxed as a collectible, and collectibles are taxed as ordinary income.

So you could own SPDR Gold for five, six, seven years, and when you do sell it, you're going to get taxed at 28%, assuming you're in the maximum tax bracket, because gold and physical commodities in general--this would be true for silver, platinum, copper even--are taxed as collectibles.

There's no avoiding the taxman on that, and the ETF structure unfortunately doesn't shield you from that instance.

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Glaser: What about ETFs that track futures and other derivatives?

Burns: Right. Commonly two of the most popular of these more esoteric-type ETFs out there are ones that track commodities and also those that are the leveraged and inverse-type funds.

A commodity-tracking ETF is going to... If it's the ETF structure, it's actually going to hold the physical futures, and commodity futures are taxed at a 60/40 long-term/short-term tax rate. You actually have to mark your portfolio to market at the end of every year.

On top of it all, those commodity ETFs are actually structured as limited partnerships, not to get too into the weeds here. So investors that own those funds in a taxable account should make sure that they wait for the K-1 statements to show up in the mail.

A K-1 is what a limited partnership has to distribute to show whether or not there's any unqualified income. These funds, none of them have paid out any unqualified income, but you should wait for the K-1. Otherwise, you're going to have to re-file your statements, your taxes to deal with that.

Now the leveraged funds are similar. They're not using commodity futures; they're using more financial derivatives to gain their leverage or their inverse exposure. Again, those are also taxed, all short-term cap gains, partly because the portfolio's turning over so often, and you're going to have to mark your holdings to market at the end of the year.

Another thing with the leveraged funds is that they have been known historically to pay out fairly large cap gains distributions. Some paid out almost 80% of the total assets under management in 2008. That was a very extreme case.

I will say this year that the leveraged ETF providers did a great job, and none of them actually paid out any cap gains distributions this year. Part of that's because they all lost money, though.

Glaser: So what are the tips that you would give investors to make sure that they're not terribly surprised come April?

Burns: Right. A big part of it is always our mantra: know what you own. Know what you own. That includes not just what's in the portfolio or what the actual index is supposed to be achieving from an investment purpose, but also what the actual structure of the fund is.

Our research spends a lot of time going into these details when it's a limited partnership on the commodity side versus an ETN, et cetera. So an investor can't just stop at the name. They can't be shocked when they own, say, United States Oil, and get a K-1 in the mail and face 60/40 taxation. That's user error, actually.

So, understanding those things and understanding how your investment thesis plays along with your tax strategy is just as key to having a good overall investment experience as being right on whether or not you think that particular fund goes up or down.

Glaser: Great. Thanks for talking with me today, Scott.

Burns: Thanks for having me.

Glaser: For Morningstar.com, I'm Jeremy Glaser.