Are ETFs taxed differently than stocks?
This is no different than the tax treatment that applies to the sale of shares in individual stocks or in mutual funds. With some exceptions for certain types of ETFs, long-term capital gains are taxed at no more than 15% (zero for investors in the 10% or 15% tax bracket; 20% for investors in the 39.6% tax bracket ).
ETFs owe their reputation for tax efficiency primarily to passively managed equity ETFs, which can hold anywhere from a few dozen stocks to more than 9,000. Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
ETF dividends are taxed according to how long the investor has owned the ETF fund. If the investor has held the fund for more than 60 days before the dividend was issued, the dividend is considered a “qualified dividend” and is taxed anywhere from 0% to 20% depending on the investor's income tax rate.
If your gain is earned for more than one year, then you are taxed at a capital gains rate of up to 28%. 7 This means that you cannot take advantage of normal capital gains tax rates on investments in ETFs that invest in gold, silver, or platinum.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
ETFs trade on the major stock exchanges at any time during the day. Prices fluctuate throughout the day like stocks. ETFs generally have lower operating expenses, no investment minimums, are tax efficient, have no sales loads, and have brokerage commissions.
Market risk
The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.
When APs redeems shares, the ETF issuer doesn't typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind”—delivering the underlying holdings of the ETF itself. No sale means no capital gains.
Not all ETF dividends are taxed the same; they are broken down into qualified and unqualified dividends. Qualified dividends are taxed between 0% and 20%. Unqualified dividends are taxed from 10% to 37%. High earners pay additional tax on dividends, but only if they make a substantial income.
What is the primary disadvantage of an ETF?
Buying high and selling low
At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business.
Put another way, when an ETF distributes capital gains to its shareholders, taxes are paid on those gains now rather than at a future time when an investor sells the ETF shares at a gain. Keep in mind that capital gains distributions generally have no impact on an ETF's performance.
Due to several operational features, ETFs generally have a more favorable structure for tax efficiency than some other investments, such as mutual funds. Actively managed strategies have delivered added performance during the past year, especially in small-cap blend equities and intermediate core bonds.
- Trading fees.
- Operating expenses.
- Low trading volume.
- Tracking errors.
- The possibility of less diversification.
- Hidden risks.
- Lack of liquidity.
- Capital gains distributions.
ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks.
A single ETF can contain dozens or hundreds of different stocks, or bonds or almost anything else considered an investable asset. Since ETFs are more diversified, they tend to have a lower risk level than stocks.
Investors who buy a "substantially identical security" within 30 days before or after selling at a loss are subject to the wash-sale rule. The rule prevents an investor from selling a security at a loss, booking that loss to offset the tax bill, and then immediately buying the security back at, or near, the sale price.
Some funds, such as money market funds or certain exchange-traded funds (ETFs), are highly liquid and allow for same-day or next-day withdrawals. On the other hand, certain alternative investment funds or funds with lock-up periods may have limited liquidity, making it difficult to withdraw your money immediately.
Short-Term: ETFs can be used for short-term trading strategies, such as taking advantage of short-term market trends or making tactical asset allocations based on short-term market conditions. Investors with short-term goals may hold ETFs for weeks, months, or a few yea.
Vanguard S&P 500 ETF holds a Zacks ETF Rank of 2 (Buy), which is based on expected asset class return, expense ratio, and momentum, among other factors. Because of this, VOO is a great option for investors seeking exposure to the Style Box - Large Cap Blend segment of the market.
Are Vanguard ETFs tax efficient?
Traditional index funds benefit from the chief factor that is responsible for ETFs' tax efficiency, and that's very low turnover. Thus, most of Morningstar's favorite core index funds are fine tax-efficient picks, especially Vanguard Total Stock Market Index and Vanguard 500 Index.
A wash sale occurs when an investor sells a security at a loss and then purchases the same or a substantially similar security within 30 days, before or after the transaction. This rule is designed to prevent investors from claiming capital losses as tax deductions if they re-enter a similar position too quickly.
| Symbol | Name | 5-Year Return |
|---|---|---|
| GBTC | Grayscale Bitcoin Trust | 63.85% |
| USD | ProShares Ultra Semiconductors | 57.79% |
| FNGU | MicroSectors FANG+™ Index 3X Leveraged ETN | 50.24% |
| FNGO | MicroSectors FANG+ Index 2X Leveraged ETNs | 47.48% |
ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
In contrast, the riskiest ETF in the Morningstar database, ProShares Ultra VIX Short-term Futures Fund (UVXY), has a three-year standard deviation of 132.9. The fund, of course, doesn't invest in stocks. It invests in volatility itself, as measured by the so-called Fear Index: The short-term CBOE VIX index.
