4 Proven Strategies to Reduce Taxes on Your ETFs

While the inexpensive convenience of including Exchange Traded Funds in your investment portfolio makes them a great long-term diversification tool, you should also be aware of how to invest in ETFs to make the most of their tax efficiency benefits as well.

Here are four strategies for ETF investing that will help you effectively manage and navigate the various tax consequences associated with both owning and trading these unique index funds.


1. Tax-loss Harvesting

Tax-loss harvesting is an effective method for indirectly improving your ETF returns.

If you’re wondering how to reduce taxes on your ETFs, this strategy is a good place to start.

Tax-loss harvesting simply involves selling some of your holdings at a loss, most often to offset the tax liability of a short-term capital gain elsewhere.

For example, if you hold both an ETF that has experienced a loss, and an investment that has experienced a significant gain within its first year, you could consider selling both investments during the same calendar year to reduce the relatively high tax liability that will apply to the winning investment’s short-term gains.

Although US wash-sale tax rules prevent you from re-purchasing the same security you are claiming as a loss, within 30 days of selling it, this does not prevent you from taking steps to reposition yourself for future anticipated gains in that investment.

You could buy shares in an ETF that tracks a different index benchmark than your original holding, but that provides a closely correlated returns performance.

Or, if the loss occurred in an individual stock holding, you could purchase an ETF that tracks the same market sector as your stock was in.


2. Long-term Capital Gains Treatment

ETF investing lends itself to more favorable tax consequences than mutual funds, since Exchange Traded Funds are specifically designed to passively track their various market indexes, and therefore require little internal turnover of their holdings.

Every time an actively managed mutual fund sells a security, the shareholder becomes liable for the associated capital gain or loss for tax purposes. ETFs are also structured to allow in-kind transactions that are not considered sales, and therefore do not trigger capital gains.

When you sell your ETF, however, you will be subject to declaring either a short-term or a long-term capital gain or loss, depending on the length of time you held the fund.

Long-term capital gains are taxed more favorably in the United States than short-term ones, but require that an investment is held for longer than one year before it’s sold.

Whereas short-term capital gains on investments held for less than a year are taxed at regular income rates, long-term tax rates are generally capped at 20% in most cases.


3. Qualified Dividends

Dividend-generating ETFs can be a great way to boost the income portion of your investment portfolio, but you should be aware that not all dividends are created equal in terms of taxation.

There is an important difference between those dividends that are considered ordinary, and those that are recognized as qualified.

Most common or preferred stocks, including those held by most ETFs, issue ordinary dividends which are taxed at regular rates for the year they were paid out.

Qualified dividends, on the other hand, are taxed much more favorably in the United States, at the lower rates applied to most long-term capital gains.

If you seek out those ETFs that offer qualified dividends, you stand to benefit from lower taxation on your returns.

Naturally, you should always confirm with the ETF provider whether their dividends are considered by the IRS to be ordinary or qualified, but most qualified dividends include those paid by an American or eligible foreign company, and that have been held for a required period of time.


4. Special Tax Treatment Sectors

There are some stock market sectors, including currency, precious metals, and futures, that don’t follow the general tax rules applied to other types of ETFs, and that usually end up with higher investor tax liabilities as a result.

As their name implies, currency ETFs hold groupings of various currencies in order to mimic their movements within the foreign exchange market. While they can be structured in a variety of ways, most currency ETFs take the form of grantor trusts, with any profits being taxed at regular income rates in the hands of the investor, regardless of how long the ETF has been held.

The silver, gold or platinum stocks held by metals ETFs are regarded as collectibles for tax purposes, rather than as regular securities, and as such they do not benefit from long-term capital gains tax rates. If you buy and sell these ETFs at a profit within one year, your gains will be taxed at your ordinary income rate, but beyond that timeframe, the tax rate on any gains is about 28%.

The other type of ETF that receives special tax treatment is the futures ETF. These funds are somewhat more complicated, and involve investing in futures contracts for a variety of commodities, bonds, currencies and other stocks. For tax purposes, any gains earned within these ETFs, distributed or not, will be reported to you at the end of the year by the provider, and you will be responsible for paying a special tax on those gains that encompasses a 60/40 blend of your long-term and short-term capital gains tax rates.


The Bottom Line

In their most basic form, regular ETFs that are held for the long-term result in a very minimal tax impact for the average investor, since many defer any tax implications until they are sold.

For more actively managed ETF portfolio strategies, short-term losers held for less than a year can be sold to take advantage of their short-term capital losses, while those showing gains can be held beyond one year to benefit from lower long-term capital gains tax rates.

In addition, ETF tax-harvesting strategies allow you to minimize the tax consequences of any gains within your portfolio by selling both short-term losers and winners within the same year, in order to offset one against the other.

Disclaimer: The contents of this article are for informational and entertainment purposes only and should not be construed as financial advice or recommendations to buy or sell any securities.

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