ETF Taxation

 

With ETFs, ordinary investors buy and sell ETF shares from other investors (unlike a traditional open-end mutual fund). Actual ETF shares are created and redeemed through institutional investors through in-kind transactions. With this design, selling shares by one investor never forces the underlying ETF to sell underlying securities to come up with the cash to pay off the investor. The cost of trading securities is borne by the investor, not the ETF.

 

The inner workings of an ETF allow its manager to make tax-wise decisions about which securities to distribute and whether to sell securities or distribute them in in-kind (to the institutional “intermediary”). ETFs can internalize losses and externalize gains. Thus, when an index change requires an ETF to get rid of stock that has dropped in price since the ETF purchased it, the ETF can make the sale on the open market, collect the cash and take the capital loss on its books. If the ETF is going to sell a stock for a gain, it can pass that stock on to an institution, removing any possible capital gains.

 

While most equity ETFs are tax efficient, ETFs that trade in commodities and futures contracts are regulated as commodity pools and taxed differently—any distributions of gains are subjected to a 60% long-term capital gains and 40% short-term rate. Gains on ETFs that hold gold, silver or other precious metals are taxed at the collectibles rate of a straight 28% on all gains. Some of these non-stock ETFs send investors a Schedule K-1 rather than the more common 1099 form.