Exchange-traded funds (ETFs) are popular investments that function similarly to mutual funds. ETFs are a kind of security basket that tracks the performance of an underlying asset, such as an index, currency, or commodity. They trade similarly to stocks, allowing investors to purchase and sell shares on stock markets.
If you want to invest in exchange-traded funds, you need understand how they function, as well as any tax considerations that may apply. These investments are taxed in the same way as the underlying asset:
- An ETF consists of equities is taxed in the same manner as the sale of those stocks.
- If you own an ETF for more than a year and sell it for a profit, you must pay capital gains tax.
- If you own it for less than a year, any earnings are considered regular income.
Although the necessary taxes are typically identical, there are certain exceptions for specific kinds of ETFs and dividends that fulfill particular conditions.
- Some ETFs, but not all, will pay dividends to owners.
- Not all ETF payouts are taxed the same way, and they are classified as qualified or unqualified dividends.
- Qualified dividends are taxed at a rate ranging from 0% to 20%.
- Unqualified dividends are taxed at a substantially higher rate, ranging from 10% to 37%.
- High-income individuals pay more tax on dividends, but only if their income is large.
Qualified vs. Unqualified Dividends
Dividends that are qualified are taxed at a lower capital gains tax rate than unqualified or regular dividends. Qualified dividends are taxed at different rates depending on the investor’s tax bracket.
The reduced capital gains tax rate on qualified dividends is due to the payout satisfying particular standards imposed by the Internal Revenue Service (IRS).The IRS requires the following requirements:
- The dividend must be paid by a firm based in the United States or a qualified foreign entity.
- Previously, the IRS did not consider the dividends to be qualified dividends.
- The holding period is met
Dividends that are not eligible are taxed at the federal income tax rate. For the 2022 tax year, this might vary from 10% to 37%. The majority of dividends fall into this category since they are unqualified by default. They are only qualified if the aforementioned requirements are pursued and satisfied.
The majority of ETFs are managed passively, with just a tiny fraction of the market handled actively.
ETF Dividend Taxation
Let us first establish that ETFs that carry equities often pay dividends quarterly or once a year, whereas ETFs that hold bonds typically pay interest monthly. If you’re going to invest in a stock ETF, be sure it delivers eligible dividends.
To be eligible for a qualifying dividend, you must hold an ETF for at least 60 days within the 121-day period beginning 60 days before the ex-dividend date and ending 60 days after that date. This is the final day for new owners to be eligible for the next payout.
Current qualifying dividend tax rates are 0%, 15%, and 20%, depending on your filing status and tax bracket. If you keep the stock for less than 60 days within that 121-day period, however, the dividends are not taxed as qualified dividends.
If you are in one of the lowest tax categories, you may be able to pay no taxes on eligible ETF dividends. You would still have to pay taxes if you sold the ETF, but you would not have to pay taxes if you met the qualifying dividend conditions for holding noted above.
This level is $41,675 for single taxpayers in 2022. You would not pay taxes on qualifying dividends if your modified adjusted gross income (MAGI) was less than this amount. For incomes between $41,675 and $459,750, the next dividend rate is 15%. Individuals earning more will pay 20% on eligible dividends.
Dividends are taxed as regular income if you hold an ETF for less than 60 days. Form 1099-DIV will be used to record all dividend income. This, of course, only pertains to the dividend. All sales of an ETF within one year would result in a short-term capital gains tax, which is far greater than the tax you would have paid if you had held it for a year or longer.
Individuals in the highest tax rates will face an extra 3.8% net investment income tax (NIIT).This threshold is $200,000 for single filers. The filing fee for a married couple filing jointly is $250,000, while the filing fee for a single person filing separately is $150,000. The NII tax is triggered by income amounts depending on the filing person’s modified adjusted gross income.
ETFs only become taxable when they are sold. This offers tax benefits that favor ETF investment, distinguishing it from mutual fund investing.
Some investors believe that dividend-paying ETFs might provide a stable foundation for their holdings. It may give tax benefits as well as a consistent source of income in the form of eligible dividends. Consider two dividend-paying ETFs: the SPDR Portfolio S&P 500 High Dividend ETF (SPYD) and the Schwab U.S. Dividend Equity ETF (SCHD).
|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||$35.7 billion|
|Performance Over One Year||18.56%||11.53%|
|Annual Dividend Yield||3.63%||2.87%|
SPYD is one of the market’s largest high dividend ETFs. It tries to mirror the S&P 500 High Dividend Index. This index tracks the top 80 dividend-paying firms in the index. The ETF delivers a substantial dividend sourced mostly from large-cap equities in the utilities, financials, and real estate sectors.
The Dow Jones U.S. Dividend 100 Index is tracked by SCHD. It is similar to SPYD in that it is a simple, low-cost ETF intended to provide investors with wide exposure while paying a quarterly dividend. Texas Instruments, Pepsi, and Pfizer are the top three holdings in this ETF, which has 102 names. Financials and technology dominate the ETF, followed by consumer staples and industrials.
What Are Dividend ETFs?
Dividend ETFs may either monitor a dividend-paying index or be a dividend-paying ETF. Both are excellent long-term investment vehicles, and many investors utilize dividend ETFs as the foundation of their portfolio.
How Are You Taxed on ETFs?
The tax treatment of ETFs is the same as owning ordinary stock. ETFs held for less than a year before selling are taxed at the short-term capital gains rate. This is much greater than if you held for a year or more.
Do You Pay Taxes on ETF Dividends?
You may be excluded from paying taxes on ETF dividends in certain instances. You would need to fulfill certain income requirements as well as be receiving IRS-qualified dividends. Most consumers will have to pay taxes on their ETF dividends, which may vary from 0% to 40%.
How Are Reit ETF Dividends Taxed?
REIT ETF dividends are typically regarded as unqualified, which means they are taxed like regular income. As a result, depending on your income, you might be taxed up to 37%.
The Bottom Line
The tax implications of ETF dividends are determined by whether they are qualified or unqualified. If they are not eligible, they will be taxed at your regular income tax rate. Qualified dividends, on the other hand, are taxed at rates ranging from 0% to 20%. If you are unsure about the complexity of your income and tax rates, it is essential to consult with an experienced financial adviser and accountant.
Correction for August 13, 2022: This article has been updated to explain the regulations governing qualifying dividend holding periods.
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