With more than $80 billion invested in exchange traded funds (ETFs), they have become a very popular investment for both retail and institutional investors. While ETFs can be an integral component of a sound investment strategy, investors should understand the tax treatment of these investments in order to avoid unexpected tax consequences.
An Exchange Traded Fund Refresher
Exchange traded funds come in many shapes and sizes. In a general sense, many ETFs are similar to mutual funds in that they own a basket of investments which could include stocks, bonds or even other ETFs. While some ETFs provide investors with a very specific investment strategy (economic sectors, foreign currencies or commodities), many are broadly diversified, carry very low internal expenses and can be bought or sold intraday – like stocks or bonds. Although many ETFs are very tax-efficient, some of the more recent (and more popular) ETF offerings can create unexpected tax headaches.
The Taxation of ETFs
Because many ETFs are essentially unmanaged index funds, their tax treatment is very straight forward. Investors can buy the ETF and, with the exception of dividends generated by the stocks within the ETF and “index adjustments” (if the ETF tracks a particular index), investors do not realize a gain or loss on the investment until their ETF shares are sold.
However, some exchange traded funds employ a more complex investment structure, which can result in unfavorable tax treatment. This is especially the case for those ETFs that provide exposure to “alternative” asset classes like foreign currencies and commodities. In fact, it has been estimated that commodity ETFs can be taxed in 6 different ways and currency ETFs can be taxed in 8 different ways. Here are a few examples:
- ETFs that invest in futures contracts are required to be “marked to market” for tax purposes. That means that investors may owe capital gains taxes on unrealized capital gains.
- Investors in some commodity and currency ETFs can be taxed on unrealized gains at blended rates (short term and long term capital gains rates), which can be as high as 23% for those in higher tax brackets.
- Gold and other precious metals are considered “collectibles,” which are taxed at a rate of 28%. Capital gains generated from ETFs that invest in precious metals are also taxed as collectibles.
- Some ETFs that invest in currencies create tax liabilities for investors based on the accrued interest in an investment. This accrued interest is taxed to investor’s at their highest marginal tax bracket.
While exchange traded funds have many advantages, it is important to understand each investment in your portfolio. Maintaining a focus, not only on the merits of a particular investment, but also some of the more obscure factors can make a big difference in your after-tax rate of return.
About Beacon Financial Strategies
Beacon Financial Strategies is a Registered Investment Advisory (RIA) firm located in Raleigh, NC. Beacon professionals provide clients with a coordinated approach to financial planning, tax and investments. If you would like more information regarding Beacon’s services and fee arrangements please complete the information request form located on the Beacon Financial Strategies website.