How ETF Dividends are Taxed

ETFs — exchange-traded funds — are taxed the same as its underlying assets would be taxed. Therefore, if an ETF has all stock holdings, it gets taxed just as the sale of those stocks would be taxed. 

If you hold an ETF for more than a year, then you will pay capital gains tax. If you hold for less than one year, any profits will be treated as ordinary income. The only exception is precious metal ETFs. If a precious metal ETF actually holds precious metals, then the ETF will be taxed as a collectible, which means it will be taxed at 28%. If you’re in a tax bracket above 28%, then you will only be taxed 28%. However, this is still bad news for most investors.

Now we need to know if there are any more surprises when it comes to the way ETF dividends are taxed. 

Let’s first establish that ETFs holding stocks usually pay dividends once a year, and ETFs holding bonds usually pay interest monthly. If you’re investing in an ETF that holds stocks, then you want to make sure it's paying qualified dividends.

Qualified dividends must be paid by an American company or a qualifying foreign company, they must not be listed as an unqualified dividend with the IRS, and the holding period must have been met.

To receive a qualified dividend, you must hold an ETF for more than 60 days before the dividend is issued. The current tax rates on qualified dividends are 5%, 15% and 20%, depending on your tax bracket. The rate of 20% only applies to those in the 39.6% tax bracket. If you’re in a tax bracket higher than 25%, then a qualified dividend will be taxed at 15%. If you’re in a tax bracket lower than 25%, then a qualified dividend will be taxed at 5%. 

If you hold an ETF for fewer than 60 days, dividends will be taxed as ordinary income. All dividend income will be reported on Form 1099.

No investment is bulletproof. If the global economy was truly strengthening as is often advertised, then banks around the world wouldn’t need to step in with such aggression. (For more, see: Do Record Highs Signal a Top?)

With that out of the way, if the stock market holds up as many people expect, then iShares US Preferred Stock (PFF), which tracks the performance of the S&P U.S. Preferred Stock Index, would be an option to consider. As an ETF, the first thing you want to look at is the expense ratio. In this case, it’s 0.47%, which is just one basis point above the average expense ratio for all ETFs. PFF, at the time of this writing, it yields 6.04%. An impressive yield doesn’t mean much if the ETF depreciates, but as of June 12, 2015, this ETF has been fairly even over the past 12 months. That’s a positive when there’s a generous yield.

The same warning above applies to WisdomTree Total Dividend ETF (DTD). This ETF tracks the performance of the WisdomTree Dividend Index and comes with an expense ratio of just 0.29%. It has appreciated 5.10% over the past year and yields 2.50%. The negative is that it doesn’t offer much liquidity. Average daily trading volume is on the low side at 44,252. (For more, see: Top ETFs and What They Track.)

These are just a couple of ideas if you’re seeking ETF dividends. There are many more out there. Use these as starting points to your own research. (For more, see: 5 Dividend ETFs With Growth Potential.)

Tax obligations for ETF dividends depend on whether or not they’re qualified or unqualified dividends. If they’re unqualified dividends, they will be taxed at your normal income rate. If they’re qualified dividends, they will be taxed between 5% and 15%. If you’re looking for dividend-paying ETF ideas, you can do some research on PFF and DTD, but keep in mind they're not resilient to market downturns. (For more, see: Top ETFs of 2015: Believe the Hype?) 

Dan Moskowitz does not have any positions in PFF or DTD.