Taxation and your ETF investments

Taxation of your ETF investments is an important consideration. As we discussed in our previous post ETF Tax Efficiency vs. Mutual Funds, ETFs are quite tax efficient. Here, we summarize taxation of your ETF investments when held in a taxable account.

ETF taxation occurs in two ways. First, taxes occur when an ETF issues a dividend. Also, taxes occur when an investors sells their ETF for a gain (or loss). So, let’s first look at the preferred (lower) level of taxation available for ETFs.

ETF taxation of qualified dividends and long-term capital gains

ETFs issue two types of dividends, called qualified and non-qualified. As shown below, ETF investors prefer taxation of qualified dividends, due to their lower capital gains rates. Many stock-based ETFs issue these types of dividends. For example, the iShares core S&P 500 index ETF (ticker: IVV) currently distributes a qualified dividend yield of 2.05%. Investors who buy an ETF and sell it at least one year later also realize these preferred rates.

ETF taxation as ordinary income

Unfortunately, ETFs can also be taxed at the higher rate of ordinary income. The tables below shows the current rates and income brackets for unmarried, married, and head of household tax payers.

ETF investors face these taxes when either the ETF issues a non-qualified dividend, or is bought and sold in less than one year. Most bond-based ETFs issue non-qualified dividends. For example, the iShares Core U.S. Aggregate Bond ETF (ticker: AGG) generates non-qualified dividends, currently with a yield to maturity of 2.52%.

Don’t let the “tail wag the dog”

While taxation is an important aspect of ETF investing, it should not be the sole consideration. Indeed, Federal taxes could be minimized if one only needs the interest payments from municipal bond ETFs, like the iShares National Muni Bond ETF (ticker: MUB). But, a diversified portfolio should have a variety of asset classes. Instead, consider holding your portfolio of ETFs in a retirement account like a traditional or Roth IRA.

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