How Exchange-Traded Funds Keep the Taxman at Bay: Some Caveats to Consider
(3 of 4)
How Exchange-Traded Funds Keep the Taxman at Bay: Some Caveats to Consider
When it comes to tax efficiency, not all ETFs are created equal. Here’s why.
Things To Know
- High turnover increases the chance of taxable gains.
- Collectibles have higher tax rates than securities.
High turnover
Some track indexes that trade more often, and some even sport turnover rates that exceed 100%. This high turnover increases the chance that the fund will distribute taxable gains in the future. An investor needs to understand the strategy of the underlying index before investing.
High tax rates
Furthermore, some ETFs lack tax efficiency because of their underlying investments. ETFs that invest directly in precious metals, such as silver or gold, are taxed as "collectibles" rather than securities. That means gains are taxed at ordinary income rates up to a maximum rate of 28% rather than the current 20% for long-term capital gains on securities.
Interest
The tax-efficient structure of ETFs is also not as relevant for bond ETFs because the bulk of their returns come from interest rather than capital gains, and any interest distribution is taxed at the shareholder’s ordinary income tax rate.
Commodities
Commodity investing has become popular in the last few years. Investors in commodity funds that invest in futures contracts need to be aware of their special tax treatment. All futures funds are marked to market at the end of the year. This means that the fund must distribute all of its gains at the end of the year. These gains are taxed as follows: 60% of profits are taxed as long-term capital gains, and 40% of profits are taxed as short-term capital gains.