ETF Tax Planning after Tax Season

Your tax season is out of the way, but just because you won’t need to file another tax form for another year, it doesn’t mean that you shouldn’t think about taxes year round to better prepare for next time. One way many investors squeezed out better tax efficiency is by switching from mutual funds to exchange traded funds (ETFs).

Passive management, trading on secondary markets and in-kind redemption by authorized participants are ways that ETFs have beat mutual funds. There are various types of ETFs, each with their own different tax implications, and investors should be aware of the differences between they invest.

The plain, regular ETF that tracks a basket of equities are taxed the same as gains are taxed for equities of individual companies. For instance, ETFs that track main indexes like the Dow and S&P or specific sectors like financials and technology. The same is true for ETFs that track a basket of companies traded on foreign stock exchanges. Dividend distributions that are made from certain equity-based ETFs are also taxed the same as dividends from a single equity, and investors will need a 1099 form.

Commodities have recently been a hit with investors, but it should be noted that there are different tax treatments for physically-backed commodity ETFs and ETFs that invest in futures. Or, one may use commodity exchange traded notes (ETNs), which do not make taxable distributions and are taxed based on gains made at the time they are sold. Additionally, ETNs don’t have to deal with the K-1 form.

Futures-based commodity ETFs will have 60% of gains taxed at the long-term capital gains rate for n investor’s income class and will have 40% of gains taxed at the short-term capital gains rate, regardless of how long the ETF is held. ETFs that track single currencies or basket of currencies will also be taxed the same as futures funds. Physically-backed commodity ETFs are taxed as collectibles, which taxes gains at typically 28% versus 15% for equities. The income distributions of fixed-income ETFs are taxed as ordinary income as compared to dividend taxes.