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Portfolio > ETFs

ETFs Lessen IRS’ Sting at Tax Time

By Joyce Hanson

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The markets of late have found all kinds of reasons to love exchange traded funds, and at tax time, one of the reasons to love ETFs becomes crystal clear: tax efficiency.

If a mutual fund enjoys a capital gain when selling off an appreciated stock, holders are on the hook with the IRS for paying the capital gains tax regardless of whether they sell or whether the fund’s share price has gone up or down since the holder bought it. But while taxes can wipe out as much as two full percentage points for mutual fund investors in the highest tax brackets, such losses are very unlikely to happen in the world of ETFs, says registered investment advisor Russell Wild, president of Allentown, Pa.-based Global Portfolios.

“The bottom line is that when somebody owns an ETF, typically there are little to no pass-through capital gains on portfolio turnover” compared with a mutual fund, explains Adam Patti, chief executive of the Rye Brook, N.Y.-based ETF firm IndexIQ. “There are still long-term or short-term capital gains on an ETF when you buy or sell, that doesn’t go away, but if you have a mutual fund and you’re down 10% for the year, you could still have a pretty big tax bill on that fund if there was a lot of turnover in the fund and some of those positions made money. The ETF structure eliminates some if not all of those pass-through capital gains.”

Michael Iachini, managing director of ETF research at Charles Schwab Investment AdvisoryMichael Iachini, managing director of ETF research at Charles Schwab Investment Advisory (left), notes that stock and bond ETFs are the easiest ETFs to figure from a tax perspective, and the simplest way to deal with the tax consequences is to invest in ETFs that don’t distribute dividends. Gold or other precious-metals ETFs, on the other hand, result in a higher tax rate on long-term gains for collectibles, Iachini says.

And then there are the commodity ETFs that use futures, which are affected by contango and backwardation.

“ETFs that use futures are structured as limited partnerships, and the partnerships get more complicated,” Iachini said in a phone interview. “There’s this weird rule from IRS Publication 550 about how gains you get are treated as 60% long term, 40% short term under these commodities partnerships that have K-1s. That’s good for you if your gains are short term, but bad for you if they’re long term, because you’ll still have to count some of them as if they’re short term. You need to know what you’re getting into, otherwise you might be surprised when you get a K-1.”

Here are the essentials to keep in mind for ETFs at tax time:

The Basics

Advisors should keep in mind that ETFs that generate income—whether interest, dividends or capital gains—are best kept in a tax-advantaged retirement account, says Wild, a registered investment advisor certified by the National Association of Personal Financial Advisors (NAPFA) and author of Exchange-Traded Funds for Dummies.

“You’ll eventually need to pay income tax on any money you withdraw from those retirement accounts, but it is generally better to pay later than sooner,” writes Wild, who primarily uses ETFs to build his clients’ portfolios, in a recent blog post.

In the case of a Roth IRA, “which is often the best case of all,” you will never have to pay taxes on the earnings, the principal, what is in the account, or what you withdraw, Wild adds. “Try to put your ETFs or mutual funds that have the greatest potential for growth—REIT ETFs are great candidates—into your Roth IRA.”

The Tax-Efficient Way to Go: Stock and Bond ETFs

Iachini of Schwab notes that stock ETFs are more tax efficient than stock mutual funds because the ETFs tend not to distribute a lot of capital gains. Index-tracking ETFs don’t trade very frequently, and the way ETF shares are created and redeemed gives an ETF manager some flexibility to reduce capital gains.

“Dividends and interest payments received via ETFs are taxed just like income from the underlying stocks or bonds, with the income being reported on your 1099 statement. Profits on ETFs sold at a gain are taxed like the underlying stocks or bonds as well: current 15% maximum rate on long-term gains and ordinary income rates on short-term gains, topping out at 35%,” Iachini writes in a March 30 note, “What to Know About ETFs and Taxes.”

Collectibles and Commodities

Precious-metals ETFs backed by the physical metal itself, as opposed to futures contracts or stock in mining companies, are structured as grantor trusts. Under current IRS rules, trusts that hold precious metals are viewed as collectibles. With precious-metals ETFs, the rate on long-term gains is the collectibles tax rate, which currently tops out at 28%, according to Iachini.

As for ETFs in commodities such as oil, corn or aluminum, these funds use futures, and the use of futures can have a big impact on a portfolio’s returns due to the effects of contango and backwardation, he says.

“Another noteworthy tax feature of ETFs that hold commodity futures contracts is the 60/40 rule. This rule, from IRS Publication 550, states that any gains or losses realized by selling these types of investments are treated as 60% long-term gains (currently taxed at a maximum rate of 15%) and 40% short-term gains (currently taxed as ordinary income, at a maximum rate of 35%). This happens regardless of how long the investor has held the ETF,” Iachini writes.

The 411 on K-1s

ETFs that use futures are structured as limited partnerships, so they report shareholders’ share of partnership income on the IRS’s Schedule K-1 instead of Form 1099. Iachini notes that some investors worry about K-1s because they’re more complex to handle on a tax return, they might arrive late, and they might incur unrelated business taxable income (UBTI) that may be taxable even within an IRA.

“People hate K-1s,” IndexIQ’s Patti asserts. “If you buy a mutual fund or an ETF fund, you get a 1099 on those products, and you get that on time, and you file it, and that’s fine. But with a hedge fund, you’re getting a K-1, and typically those come out late. You have to file taxes by April, and you might not get your K-1 until June. The time varies, but they’re notoriously late.”

Commodity ETFs over all have a track record of sending K-1s in a timely manner, though admittedly sometime after most 1099s are available, and without generating UBTI, Iachini says. “K-1s are indeed more complex to handle on a tax return than 1099s, but professional tax preparers or well-informed individuals who do their own taxes should be able to handle K-1s correctly,” he writes.

For more tax tips, see AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012.

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