How are ETF distributions taxed?
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
Not all ETF dividends are taxed the same; they are broken down into qualified and unqualified dividends. Qualified dividends are taxed between 0% and 20%. Unqualified dividends are taxed from 10% to 37%. High earners pay additional tax on dividends, but only if they make a substantial income.
If you sell an equity or bond ETF, any gains will be taxed based on how long you owned it and your income. For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners.
ETF issuers collect any dividends paid by the companies whose stocks are held in the fund, and they then pay those dividends to their shareholders. They may pay the money directly to the shareholders, or reinvest it in the fund.
Under current IRS regulations, capital gains distributions from mutual fund or ETF holdings are taxed as long-term capital gains, no matter how long the individual has owned shares of the fund.
Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.
Just like a share, the dividend yield, or distribution yield, for an ETF is expressed as a percentage of the ETF's market price, providing investors with a useful measure of the income that the fund has been paying over a specified period (usually 12 months).
ETFs are built to avoid the capital gains that result from turnover and redemptions. Investors buy or sell ETF shares on a stock exchange from other investors, not the fund. This avoids the need to raise cash to meet redemptions for small investors.
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
60% of the gain or loss is taxed at the long-term capital tax rates. 40% of the gain or loss is taxed at the short-term capital tax rates.
Are ETF distributions the same as dividends?
If you own shares of an exchange-traded fund (ETF), you may receive distributions in the form of dividends. These may be paid monthly or at some other interval, depending on the ETF.
Avoiding Capital Gains
Both mutual funds and ETFs are required to distribute capital gains and income to investors at least annually. It's important to pay attention to these estimates as there can be instances where the capital gains distributed represent a significant amount relative to the asset value.
Distribution yield is defined as a way of measuring the annual income payments made to unitholders, by an A-REIT or an ETF, as a percentage or portion of its unit price.
ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor's income tax rate.
You can take distributions from your IRA (including your SEP-IRA or SIMPLE-IRA) at any time. There is no need to show a hardship to take a distribution. However, your distribution will be includible in your taxable income and it may be subject to a 10% additional tax if you're under age 59 1/2.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
Vanguard Tax-Exempt Bond ETF (VTEB)
To achieve this degree of diversification, VTEB tracks the S&P National AMT-Free Municipal Bond Index. To ensure liquidity, VTEB uses a sampling methodology to directly replicate at least 80% of the index's composition.
Rather than creating or redeeming shares through cash transactions made directly with fund investors and the underlying markets, ETFs are engaged in a separate circuit of share creation and redemption—a process of in-kind transactions that isn't considered to be a taxable event.
Essentially investors receive dividends when they're invested in individual shares. They receive distributions when they're invested in ETFs.
Do all ETFs pay distributions?
While not all ETFs pay dividends/distribution income, the vast majority do via quarterly distributions, and any stocks within the portfolio that pay a dividend, have these payouts pooled together.
Investors in mutual funds or ETFs do not actually own the shares of the companies that the funds invest in; they only own a portion of the fund. However, any shares that pay dividends, those dividends are then passed onto the investor of the mutual fund or ETF directly into their account.
Treatment of gain or loss realized on selling the ETFs: While return of capital is a form of distribution, they are considered a non-taxable event that will impact an investor's book value and therefore affect the calculation of capital gains and losses of the investor when units are sold.
So even if you held the option for a month, 60% of your gain will be considered long-term and taxed at the 20% preferential long-term capital-gains rate. The remaining 40% will be taxed at your ordinary income tax rate.
As you can see, active ETFs offer significantly greater tax efficiency than actively-managed mutual funds in three of the four asset classes we investigated. The results are especially dramatic for large and small cap equity funds where active ETFs deliver the largest reductions in taxes.
