Do ETFs Distribute Capital Gains and What You Need to Know

ETFs do distribute capital gains, but it's a complex process that's worth understanding. This is because ETFs are designed to track a specific index or sector, and as the underlying assets change hands, capital gains can be triggered.

Capital gains distributions occur when an ETF sells securities that have increased in value. For example, if an ETF owns a stock that has risen significantly in value, it may need to sell some of those shares to meet investor redemptions or to rebalance its portfolio.

The frequency and amount of capital gains distributions vary depending on the ETF. Some ETFs may distribute capital gains annually, while others may do so quarterly or semiannually.

Intriguing read: When Do Mutual Funds Pay Capital Gains

ETFs are generally more tax-efficient than mutual funds, thanks to their unique structure.

ETFs use "in-kind" transactions, which allow them to avoid triggering capital gains taxes until investors sell their ETF shares. This makes ETFs more tax-efficient than mutual funds.

Additional reading: How Are Etfs More Tax Efficient

The tax advantage is most apparent for stock funds, with over 60% of stock mutual funds distributing capital gains in 2023, compared to just 4% of ETFs.

Less than 4% of ETFs are expected to distribute capital gains in 2024, according to Morningstar.

ETFs held for more than a year are taxed at up to 20% in long-term capital gains tax, while ETFs held for less than a year are taxed at ordinary income rates.

The tax rate for ETFs is the same as the tax rate for the underlying stocks or bonds they hold.

The tax implications of ETFs can be complex, but understanding the basics can help investors make informed decisions.

Here are some key tax implications to consider:

It's essential to note that tax laws and regulations can change, and individual circumstances may affect tax implications.

Investors should consult with a tax professional to determine the specific tax implications of their ETF investments.

ETFs have a tax advantage over mutual funds due to their "in-kind" transactions. This allows them to avoid triggering capital gains taxes until investors sell their ETF shares.

In contrast, mutual fund managers buy and sell securities within the fund, passing on capital gains to investors as distributions, which are typically taxable events. This is why more than 60% of stock mutual funds distributed capital gains in 2023, compared to just 4% of ETFs.

The tax advantage of ETFs is significant, with some studies showing an average annual after-tax advantage of 0.92%. This may not seem like much, but it's enough to make a difference over time.

For example, a study found that U.S. large-cap ETFs and mutual funds have annualized 10-year returns of 10.11% and 9.95%, respectively. This means that over a decade, investors who put $100,000 in a mutual fund would have about $3,700 less than if they had invested in an ETF.

ETFs also have a lower tax burden than mutual funds in certain asset classes. For example, in the study, international equity funds showed a 0.33% post-tax performance difference between ETFs and mutual funds.

Here's a rough breakdown of the tax differences between ETFs and mutual funds:

Keep in mind that these numbers are averages and may vary depending on the specific fund and investment strategy. It's essential to consult with a financial professional to determine the best investment choice for your individual needs.

ETFs have different tax rules depending on their assets.

Profits from the sale of ETFs held for under a year are taxed as a short-term capital gain, while those held for longer are considered long-term gains and given a lower rate.

If you sell an ETF and buy the same ETF after less than 30 days, you may be subject to the wash sale rule, which means you can't offset other capital gains.

High earners are also subject to the 3.8% net investment income tax on ETF sales.

Curious to learn more? Check out: How to Avoid Capital Gains Taxes on Sale of Home

Dividends and interest payments from ETFs are taxed like income from the underlying stocks or bonds they hold.

For U.S. taxpayers, this income needs to be reported on Form 1099-DIV.

The income is taxed at your ordinary income rates, which can go up to 37%. Some individuals may also pay an additional 3.8% net investment income (NII) tax.

If you hold an ETF for more than a year, you'll pay up to 20% in long-term capital gains tax.

ETFs held for less than a year are taxed at ordinary income rates, which can go up to 37%, plus an additional 3.8% NIIT for some.

Dividends from your ETF can be either ordinary (taxable) or qualified (taxed at lower capital gains rates). Your ETF provider will specify which type you received.

For example, if your ETF holds Apple (AAPL) stock and Apple pays a qualified dividend, that money flows through the ETF to you as a qualified dividend.

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Wash sales are a common practice in tax-loss harvesting, where investors sell a security at a loss and repurchase a similar one to offset gains.

Tax experts are divided on whether this is allowed for ETFs, with no record of IRS enforcement on the matter.

A 2023 ProPublica report found that tax-loss harvesting with ETFs resides in a regulatory grey area of U.S. tax law.

Investors use ETFs to engage in tax-loss harvesting, selling an ETF at a loss and repurchasing the same one within a month can be considered a wash sale.

However, selling an ETF at a loss and repurchasing a different ETF, even if it has similar holdings and objectives, is not considered a wash sale.

This is the case even for ETFs whose returns have a 99.67% correlation, as seen in the example of WhatsApp co-founder Brian Acton.

Acton sold $17 million in shares of Vanguard’s emerging markets ETF, booking a loss of $2.9 million, and then put $17 million into Blackrock's emerging markets ETF.

Explore further: Leveraged Emerging Markets Etf

ETFs that track indexes or baskets of securities, such as the S&P 500, typically do not distribute capital gains because they do not sell securities to realize gains.

The S&P 500 ETF, for example, holds the same securities as the S&P 500 index, and the index itself does not distribute capital gains.

This is because the index is rebalanced quarterly, which means that the ETF is constantly buying and selling securities to maintain its position in the index, rather than selling securities to realize gains.

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Currency ETFs are a special case when it comes to taxes. They're typically structured as grantor trusts, which means the profit from the trust creates a tax liability for the ETF shareholder, taxed as ordinary income.

Futures ETFs, on the other hand, trade commodities, stocks, Treasury bonds, and currencies. Gains and losses on these ETFs are treated for tax purposes as 60% long-term and 40% short-term, no matter how long the ETF held the contracts.

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Metals ETFs are considered collectibles for tax purposes. If your gain is short-term, it's taxed as ordinary income. If your gain is earned for more than a year, you're taxed at a capital gains rate of up to 28%.

Here's a breakdown of the tax implications for each of these types of ETFs:

Crypto investments can have different tax implications depending on the type of investment you hold.

Spot crypto ETFs, which hold actual cryptocurrency, are treated similarly to spot commodity ETFs for tax purposes.

If a spot crypto ETF makes distributions to shareholders, these distributions may be taxed as ordinary income.

Crypto ETFs invested in futures contracts, on the other hand, are subject to the 60/40 rule.

This rule treats 60% of gains or losses as long-term capital gains or losses, and the remaining 40% as short-term.

The specific tax treatment for crypto investments can depend on your jurisdiction, the ETF structure, and other factors.

Crypto ETFs are a relatively new investment option, and tax laws and regulations surrounding them may change.

On a similar theme: Crypto Etfs on Robinhood