ETF Tax Advantages Over Mutual Funds
One major benefit of an ETF is the tax advantage it holds over a mutual fund. ETFs are more tax-efficient due to their construction and the way the IRS classifies them. Specifically, capital gain taxes are only realized on an ETF when the entire investment is sold whereas a mutual fund incurs capital taxes every time the assets in the fund are sold.
Mutual Fund Taxes
Whenever you sell an asset for a profit, the government wants its share of the pie. The tax on this profit is known as the capital gain tax. If you make money, the government makes money.
Since a fund manager actively trades the assets in a mutual fund, every time equities are sold for a profit; capital gain taxes must be paid. Over time, that can add up to a lot of frequent tax incursions.
There are capital gain taxes to be paid on the profitable sale of an ETF also, but with a major difference. The capital gain tax on an asset in an ETF is only paid when the entire ETF sold, not while you are holding the ETF.
While ETF assets are not as actively traded like equities in mutual funds, there may be some stocks in the ETF that need to be changed or replaced due to readjustments. However, the taxes on any gains from the sales of these assets are delayed until the entire ETF is sold. Any time you can hold on to your money is a good time.
Taxes on ETF Dividends
As for taxes from dividend ETFs, things are a little different. There are two kinds of dividends that the stocks in an ETF may issue. Qualified dividends and unqualified dividends. For an ETF dividend to be taxed as qualified, the equity in the fund paying the dividend must be owned by the investor for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Also, it cannot be on the unqualified dividend list, and a U.S. or qualified foreign corporation must pay it.
The tax rate on qualified dividends is anywhere from 5% to 15%, depending on your income tax rate. If you have an income tax rate of 25% or higher, then your qualified dividend is taxed at 15%. If your income tax rate is less than 25%, then your qualified dividends are taxed at 5%.
In the case of unqualified dividends, payouts that do not meet the qualifications discussed above and are dividends that the government does not consider true dividends. Some examples include dividends on money market accounts, dividends on short-term mutual fund capital gains, interest from your credit union, dividends in your IRA, and dividends from REITs (real estate investment trusts).
In the case of unqualified dividends, these payouts are taxed at your normal income tax rate. So if you have unqualified dividends from the ETFs in your portfolio, then they will have a heavier tax burden than the normally qualified dividends from these securities. So there is not a tax advantage on unqualified dividends from ETFs, but there are benefits for cases with qualified dividends.
In conclusion, an ETF holds two major tax advantages over a mutual fund. Mutual funds usually incur more capital gains taxes than ETFs due to the frequency of trading activity. Also, the capital gain tax on an ETF is delayed until the sale of the product. However, mutual funds incur taxes during the life of the investment.
And these advantages are not just limited to ETFs, but ETNs (exchange-traded notes as well). And as with any investment, it's important to know all the implications that are involved. So before you get started with ETFs, make sure you understand how they are going to affect your tax return.