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Profits you make from selling an exchange-traded fund (ETF) are taxable just like the profits from selling a stock or withdrawing money from a mutual fund. Dividends received from an ETF are taxable as well.
Key Takeaways
- Some but not all equity ETFs pay dividends to their shareholders.
- Not all ETF dividends are taxed the same. They’re broken down into qualified and unqualified dividends.
- Qualified dividends are taxed from 0% to 20%.
- Unqualified dividends are taxed from 10% to 37%.
- High earners pay additional tax on dividends but only if they have substantial income.
Overview: ETFs and Taxes
An ETF is a selection of investments that can include stocks, bonds, currencies, or commodities. Most ETFs select their investments to precisely mimic an index such as the S&P 500 or the Russell 2000 Index. This makes them “passively managed” and it’s why the fees are so low. No buying and selling decisions have to be made from day to day. The performance tracks the index as closely as possible.
The tax implications for their investors are virtually the same as those for the investments that are included in the fund. The tax treatment is similar to that of the underlying asset: You owe the taxes if you make a profit.
Taxes From Sale of Stock ETF Shares
You’re taxed for an ETF composed of stocks in the same way as you would be if you had sold those stocks.
- You’ll pay capital gains tax if you hold an equity ETF for more than a year and make a profit on its sale
- The profits are treated as ordinary income if you hold it for one year or less. The tax will be the same as what you owe on your other income for the year based on your tax bracket. This is higher than the capital gains rate for many people.
The required taxes are usually similar but there are extenuating circumstances for certain types of ETFs and their dividends provided that they meet certain criteria.
Taxes on Commodity or Currency ETFs
You can expect different tax requirements for ETFs that invest in commodities, precious metals, or currencies because the tax rules for these underlying assets aren’t the same as the rules for stocks.
Qualified vs. Unqualified Dividends
Qualified dividends are taxed at a lower capital gains tax rate than unqualified or ordinary dividends. Qualified dividends are taxed at 0% to 20% depending on the investor’s tax bracket. The lower rate is applied to dividends that meet certain requirements put in place by the Internal Revenue Service (IRS):
- The dividend must be paid by a U.S. company or a qualifying foreign company.
- The dividends weren’t previously excluded by the IRS as qualified dividends.
- The holding period is met.
Unqualified dividends are taxed at the taxpayer’s federal income tax rate. These rates are adjusted annually by the IRS.
Most dividends fall into this category because they’re considered unqualified by default. They only become qualified if the above criteria are pursued and met.
Fast Fact
Most ETFs are passively managed. The holdings only change when the index or other benchmark it parallels is revised.
ETFs and Dividend Taxation
The stocks held by ETFs usually pay dividends quarterly or once a year. ETF holding bonds usually pay interest monthly. Make sure it pays qualified dividends if you’re investing in an ETF that holds stocks.
Qualified Dividends
You must hold an ETF for more than 60 days during a 121-day period to receive a qualified dividend. The period begins 60 days before the ex-dividend date and ends 60 days after that date. This is the last day when new owners can qualify for the next dividend.
The tax rates on qualified dividends are 0%, 15%, and 20%, depending on your filing status and your tax bracket. The dividends aren’t taxed as qualified dividends, however, if you hold the stock for fewer than 60 days during that 121-day period.
You could pay 0% taxes on qualified ETF dividends if you’re in one of the lower tax brackets. You would still pay tax when you sold the ETF itself but you wouldn’t pay taxes as long as you satisfy the qualified dividend requirements for holding.
You would pay no taxes on qualified dividends as long as your modified adjusted gross income (MAGI) is below the threshold income announced by the IRS for that year. The next dividend rate is 15% for incomes between the next threshold. Finally, individuals with incomes exceeding the highest threshold will pay a 20% tax on their qualified dividends.
Unqualified Dividends
Dividends will be taxed as ordinary income if you hold an ETF for less than 60 days. All dividend income is reported on Form 1099-DIV.
This only applies to the dividend, however. All sales of ETFs in one year or less will result in a short-term capital gains tax. This is significantly higher for most taxpayers than the tax you would pay if you had held it for more than a year.
Individuals who are in the highest tax brackets will be required to pay an additional net investment income tax (NIIT). The income amounts that trigger the NIIT are based on the filing person’s MAGI.
Important
ETFs only trigger a taxable event when they’re sold. This is a tax advantage that favors ETF investing and it differs from investments in mutual funds.
Dividend ETFs
Some investors find that having dividend-paying ETFs can add a solid core to their portfolios. It can offer tax advantages as well as provide a steady stream of income in the form of qualified dividends.
Let’s take a look at an example of two dividend-paying ETFs: The SPDR Portfolio S&P 500 High Dividend ETF (SPYD) and the Schwab U.S. Dividend Equity ETF (SCHD).
| Example: SPDR Portfolio S&P 500 High Dividend ETF vs. Schwab U.S. Dividend Equity ETF | ||
|---|---|---|
| SPDR Portfolio S&P 500 High Dividend ETF (SPYD) | Schwab U.S. Dividend Equity ETF (SCHD) | |
| Issuer | State Street | Schwab Asset Management |
| Inception Date | Oct. 21, 2015 | Oct. 20, 2011 |
| Assets Under Management | $6.8 billion | $52.2 billion |
| Expense Ratio | 0.07% | 0.06% |
| Annual Dividend Yield | 4.67% | 3.62% |
SPYD is one of the larger high-dividend ETFs on the market. It aims to track the High Dividend Index of the S&P 500. This index measures the 80 highest-dividend-yielding companies in the index. The ETF pays a healthy dividend which is derived from mostly large-cap stocks in financials, utilities, and real estate.
SCHD tracks the total return of the Dow Jones U.S. Dividend 100 Index. It’s similar to SPYD because it’s a relatively straightforward, low-cost ETF that’s designed to offer investors broad exposure while providing a quarterly dividend payment. This ETF’s top three holdings out of 104 names are Abbvie, Merck, and Broadcom. The ETF is heavy in industrials, financials, and consumer staples.
What Are Dividend ETFs?
Dividend ETFs can track either a dividend-paying index or an ETF that pays a dividend to its shareholders. Many investors use dividend ETFs as the core of their portfolio.
How Will I Be Taxed on ETFs?
Tax rates on ETFs are the same as those for holding common stock. ETFs that are held for one year or less before they’re sold are taxed at the short-term capital gains tax rate. This is much higher for most taxpayers than if they were held for longer than a year.
Will I Pay Taxes on ETF Dividends?
You could be exempt from paying taxes on ETF dividends in some cases. You would have to meet specific income criteria and receive dividends that are deemed qualified by the IRS.
People will pay taxes on their ETF dividends in most cases. These rates range from 0% to 37% depending on the taxpayer’s income tax bracket.
How Are REIT ETF Dividends Taxed?
Dividends paid by REIT ETFs are generally considered unqualified so they’re taxed as ordinary income. You may be taxed up to 37% depending on your marginal income tax rate.
The Bottom Line
Taxes on ETF dividends depend on whether they’re classified as qualified or unqualified. They’ll be taxed at your normal income rate if they’re unqualified. Qualified dividends are taxed between 0% and 20%.
Consider discussing an ETF dividend strategy with a qualified investment advisor or accountant if you aren’t clear on the complexities involved in your income and tax brackets.
