Tax efficiency has long been sold as among the greatest advantages of ETF investing. Although that may have been true ten years ago, when most ETFs were linked to traditional stock and bond indexes, it isn't necessarily true anymore.
Since their infancy in the early 1990s, the dynamics of investing in ETFs have changed dramatically. This has been led by the ETF industry's expansion into new asset classes like commodities and currencies along with product structures that resemble ETFs but aren't technically ETFs. For this reason, it's wrong for advisors and their clients to assume that all products with the ETF label are automatically tax efficient beasts.
How can you make tax savvy investment decisions? Know what you're buying.
In response to the broadening reach of ETFs, this very column has been changed to adapt with the times. It's now called "ETP Reporter," because "ETP" encompasses not just ETFs but products that trade in the same fashion and yet utilize a different structure.
Among the non-ETF products that fall under the ETP heading are grantor trusts, partnerships and exchange-traded notes (ETNs). These product types are well suited for asset classes like commodities and currencies, and they have helped financial advisors to build investment portfolios that diversify beyond stocks, bonds and cash.
Yet, while ETPs are sometimes referred to as "ETFs" by the mainstream media it's important to understand they may not necessarily have the same friendly tax treatment as traditional ETFs. Let's evaluate the taxation of popular ETP structures. In each of these examples, we will assume these investments are being held in taxable investment accounts.
Grantor Trust
The Grantor Trust is a financial structure typically used by commodity or currency focused ETPs. The SPDR Gold Shares (GLD), iShares COMEX Gold Trust (IAU) and the iShares Silver Trust (SLV) are noteworthy examples of ETPs that use the grantor trust architecture.
Some investors fool themselves into thinking the ETP label is giving them a tax break on their investments in gold or silver, but this is hardly the case.
ETPs that hold physical bullion, like GLD or SLV, are taxed at a maximum capital gains rate of 28 percent, which is higher compared to other investments, like stocks. Under current tax law, profits from securities are taxed at a maximum long-term capital gain rate of zero percent for those in the 10 or 15 percent income tax bracket and 15 percent for people in higher brackets.
Grantor trusts with physical metals do not distribute realized capital gains nor do they generate interest income. However, there's always an outside chance your clients might receive a K-1 or a Form 1099, so always keep on the watch.
ETPs Invested in Futures
Many grantor trusts and partnerships hold futures contracts on currencies or commodities. For instance, the iShares S&P GSCI Commodity Indexed Trust (GSG) contains futures contracts on 24 commodities including corn, gold, live cattle, oil, natural gas, soybeans and wheat. How are they taxed?
Commodity linked products that utilize futures to obtain their market exposure are taxed at a 60/40 rate, regardless of the holding period. Thus, 60 percent of gains are taxed at the long-term capital gains rate while the remaining 40 percent are taxed as short- term profits, subject to the investor's ordinary income tax rate. For investors in the highest tax bracket, this 60/40 split creates a maximum blended capital gains tax rate of 23 percent. The tax burden is reduced for investors in lower income brackets.
Finally, an investor in these types of products may be taxed each year, even if they do not sell the investment. Likewise, interest income must be recognized.
Exchange-Traded Notes
