The profits you make from selling an exchange-traded fund (ETF) are taxable, just like the profits from selling a stock or withdrawing money from a mutual fund. If you receive dividends from an ETF, they are taxable as well.
As usual, the details are a bit complicated.
Key Takeaways
- Some but not all equity ETFs pay dividends to their shareholders.
- 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.
Overview: ETFs and Taxes
An ETF is a selection of investments that might include stocks, bonds, currencies, or commodities. Most ETFs select their investments to precisely mimic an index such as the S&P 500 or the Russell 2000 Index.
That makes them "passively-managed" funds, and it's why the fees are so low. No buying and selling decisions need to be made from day to day. The performance tracks the index as closely as possible.
For their investors, the tax implications are virtually the same as those for the investments that are included in the fund. The tax treatment of these investments is similar to that of the underlying asset:
In short, if you make a profit you owe the taxes.
Taxes from Sale of Stock ETF Shares
You're taxed for an ETF composed of stocks in the same way as the sale of those stocks.
- If you hold an equity ETF for more than a year and make a profit on its sale, you will pay capital gains tax.
- If you hold it for less than one year, the profitsare treated as ordinary income. The tax will be the same as you owe on other income for the year, given your tax bracket. For many, this is higher than the capital gains rate.
Although the required taxes are usually similar, there are extenuating circ*mstances for certain types of ETFs and their dividends, provided they meet certain criteria.
Taxes on Commodity or Currency ETFs
For ETFs that invest in commodities, precious metals, or currencies, you can expect different tax requirements.
That's because the tax rules for these underlying assets are different from the rules for stocks .
Qualified vs. Unqualified Dividends
Qualified dividends are taxed at a lower capital gains tax rate than unqualified or ordinary dividends. Depending on the investor's tax bracket, qualified dividends are taxed at 0% to 20%.
The lower rate is applied to dividends that meet certain requirements put in place by the Internal Revenue Service (IRS). The following are the requirements:
- The dividend must be paid by a U.S. company or a qualifying foreign company.
- The dividends weren't previously excluded by the IRS as qualified dividends.
- The holding period is met.
Unqualified dividends are taxed at the taxpayer's federal income tax rate. This ranges from 10% to 37% for the 2023 and 2024 tax years.
Most dividends fall into this category as they are considered unqualified by default. They only become qualified if the above criteria are pursued and met.
Most ETFs are passively managed. The holdings only change when the index or other benchmark it parallels is revised.
ETFs and Dividend Taxation
The stocks that are held by ETFs usually pay dividends quarterly or once a year. ETFs holding bonds usually pay interest monthly. If you’re investing in an ETF that holds stocks, make sure it pays qualified dividends.
Qualified
To receive a qualified dividend, you must hold an ETF for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date and ends 60 days after that date. This is the last day when new owners can qualify for the next dividend.
The current tax rates on qualified dividends are 0%, 15%, and 20%, depending on your filing status and tax bracket. However, if you hold the stock for fewer than 60 days during that 121-day period, the dividends are not taxed as qualified dividends.
You could pay 0% taxes on qualified ETF dividends if you are in one of the lower tax brackets. Granted, you would still pay tax when you sold the ETF itself, but would not pay taxes as long as you satisfy the qualified dividend requirements for holding mentioned above.
For single taxpayers, this threshold is $44,625 for 2023 and $47,025 for 2024. As long as your modified adjusted gross income (MAGI) is below this level, you would pay no taxes on qualified dividends. The next dividend rate is 15% for incomes between $44,625 and $492,300 for 2023 and 47,025 and $518,900 for 2024. Individuals who make more will pay a 20% tax on their qualified dividends.
Unqualified Dividends
If you hold an ETF for fewer than 60 days, dividends will be taxed as ordinary income. All dividend income is reported onForm 1099-DIV.
Of course, this only applies to the dividend. All sales of an ETF under one year will result in a short-term capital gains tax, which for most taxpayers is significantly higher than the tax you would pay if you would have held it for a year or more.
Individuals who are in the highest tax brackets will be required to pay an additional 3.8% net investment income tax (NIIT). For single filers, this threshold is $200,000. Married filing jointly is $250,000, and filing separately is $150,000. The income amounts that trigger the NIIT are based on the filing person's MAGI.
ETFs only trigger a taxable event when they are sold. This is a tax advantage that favors ETF investing, and it differs from investments in mutual funds.
Dividend ETFs
Some investors find that having dividend-paying ETFs can add a solid core to their portfolios. It can offer tax advantages as well as provide a steady stream of income in the form of qualified dividends.
For an example, let's take a look at two dividend-paying ETFs: The SPDR Portfolio S&P 500 High Dividend ETF (SPYD) and the Schwab U.S. Dividend Equity ETF (SCHD).
| SPDR Portfolio S&P 500 High Dividend ETF vs. Schwab U.S. Dividend Equity ETF | ||
|---|---|---|
| SPDR Portfolio S&P 500 High Dividend ETF (SPYD) | Schwab U.S. Dividend Equity ETF (SCHD) | |
| Issuer | State Street | Schwab Asset Management |
| Inception Date | Oct. 21, 2015 | Oct. 20, 2011 |
| Assets Under Management | $6.8 billion | $52.2 billion |
| Expense Ratio | 0.07% | 0.06% |
| Annual Dividend Yield | 4.67% | 3.62% |
SPYD is one of the larger high-dividend ETFs on the market today. It aims to track the High Dividend Index of the S&P 500. This index measures the 80 highest-dividend-yielding companies in the index. The ETF pays a healthy dividend which is derived from mostly large-cap stocks in financials, utilities, and real estate.
SCHD tracks the total return of the Dow Jones U.S. Dividend 100 Index. It is similar to SPYD above as it is a relatively straightforward, low-cost ETF designed to offer investors broad exposure while providing a quarterly dividend payment. Out of 104 names, this ETF's top three holdings are Abbvie, Merck, and Broadcom. The ETF is heavy in industrials, financials, and consumer staples.
What Are Dividend ETFs?
Dividend ETFs can either track a dividend-paying index or an ETF that pays a dividend to its shareholders. Many investors use dividend ETFs as the core of their portfolio.
How Are You Taxed on ETFs?
Tax rates on ETFs are the same as those for holding common stock. ETFs held less than a year before they are sold are taxed at the short-term capital gains tax rate. For most taxpayers, this is much higher than if they were held for a year or longer.
Will I Pay Taxes on ETF Dividends?
In some cases, you could be exempt from paying taxes on ETF dividends. You would need to meet specific income criteria, as well as be receiving dividends deemed qualified by the IRS.
In most cases, people will be paying taxes on their ETF dividends. This will range from 0% to 37% depending on the taxpayer's income bracket.
How Are Reit ETF Dividends Taxed?
Dividends paid by REIT ETFs are generally considered unqualified, which means they are taxed as ordinary income. As such, you may be taxed up to37% depending on your income threshold.
The Bottom Line
Taxes on ETF dividends depend on whether they’re classified as qualified or unqualified. If they’re unqualified, they will be taxed at your normal income rate. Qualified dividends are taxed between 0% and 20%.
Discussing an ETF dividend strategy is best done with a qualified investment advisor and accountant if you are not clear on the complexities involving your income and tax brackets.
Correction—Aug. 13, 2022: This article has been updated to clarify the rules surrounding the holding period for qualified dividends and to make clear who is eligible for those dividends.
As an enthusiast with a deep understanding of financial markets and taxation, let me provide you with insights into the concepts discussed in the article about the taxation of Exchange-Traded Funds (ETFs). My knowledge is grounded in practical experience and extensive research in the field of finance.
Exchange-Traded Funds (ETFs): ETFs are investment funds that hold a diversified portfolio of assets, such as stocks, bonds, currencies, or commodities. Unlike actively managed funds, most ETFs aim to replicate the performance of a specific index, making them passively managed and cost-effective.
Taxation of ETF Profits:
- ETF profits, similar to stock gains or mutual fund withdrawals, are taxable.
- Holding an equity ETF for more than a year and making a profit on its sale incurs capital gains tax. If held for less than a year, profits are treated as ordinary income.
Taxation of ETF Dividends:
- Some but not all equity ETFs pay dividends to shareholders.
- ETF dividends can be categorized as qualified or unqualified.
- Qualified dividends are taxed at a lower capital gains rate (0-20% depending on the tax bracket).
- Unqualified dividends are taxed at the taxpayer's federal income tax rate (10-37%).
Tax Considerations for Different Types of ETFs:
- ETFs investing in commodities, precious metals, or currencies may have different tax requirements due to distinct underlying asset rules.
Dividend Taxation and Holding Period:
- ETFs holding stocks usually pay dividends quarterly or annually.
- To receive qualified dividends, an investor must hold an ETF for more than 60 days during a 121-day period around the ex-dividend date.
- Qualified dividend tax rates range from 0% to 20%, based on income and filing status.
Dividend ETFs:
- Dividend ETFs track either a dividend-paying index or an ETF that pays dividends.
- Investors often use dividend ETFs as the core of their portfolios for potential tax advantages and a steady income stream.
Case Study - SPDR Portfolio S&P 500 High Dividend ETF (SPYD) vs. Schwab U.S. Dividend Equity ETF (SCHD):
- Provides a comparison of two dividend-paying ETFs, highlighting their inception dates, assets under management, expense ratios, and annual dividend yields.
Tax Considerations for REIT ETF Dividends:
- Dividends paid by Real Estate Investment Trust (REIT) ETFs are generally considered unqualified, taxed as ordinary income (up to 37% depending on income).
Tax Planning and Consultation:
- Tax rates on ETFs mirror those for common stocks.
- Planning an ETF dividend strategy is recommended with guidance from qualified investment advisors and accountants to navigate complexities related to income and tax brackets.
In conclusion, understanding the tax implications of ETFs involves considerations of holding periods, dividend classifications, and the specific nature of the underlying assets. Tax planning should be tailored to individual circ*mstances and often benefits from professional advice.
