ETF Tax Rules

ETF investments have increased in popularity.

Investing can increase the value of savings accounts. Exchange Traded Funds (ETFs) are investment funds that are traded throughout the day in an appropriate business exchange. According to MSN Money, these accounts have grown in popularity because they have low annual expenses and because they allow investors to invest in a particular sector without the volatility of investing in a single stock. However, investors should consider the tax regulations surrounding specific types of ETFs before purchasing these funds.

Commodity

ETFs dealing with a certain commodity, particularly in the case of precious metals, are taxed at the time of sale at ordinary income tax rates. These taxes typically are higher than capital gains tax rates. Additionally, these funds do not generate interest income, and gains are not redistributed into accounts.

Leverage

Leverage ETFs are a kind of exchange-traded fund that does not use stocks and bonds to track the price of shares. Instead, money is pooled, and the shares are priced at a set rate. This may result in costly capital gains taxes for shareholders. Additionally, even if investors hold shares for longer than one year, they may face capital gains taxes at short-term rates. Leverage ETFs "tend to be less tax efficient" than other kinds of ETFs, according to Morningstar online magazine. Still, because of low commissions and liquidity (the ability of investors to cash in on investments) of leverage ETF's, they may work well for certain investors.

Futures

ETF futures contracts are promises to eventually purchase a particular investment at a certain date. They are considered riskier than other kinds of ETFs. They can involve any kind of investment (stocks, bonds, commodities, treasuries, for example). When these ETFs are held in a regular brokerage account, gains are subject to taxation. Regardless of whether they are sold, they will be taxed every year (capital gains will be taxed 60 percent at long-term rates and 40 percent at short-term), and any income generated by these accounts must be claimed as income that will be taxed again. However, if ETF futures are held in an IRA (Individual Retirement Account), capital gains are not taxed every year and income generated in IRAs is only taxed upon withdrawal.

UBTI

An IRS clause known as the Unrelated Business Taxable Income (UBTI) is an additional tax that may be tacked on to certain ETF accounts that can make even tax-deferred accounts like IRAs immediately taxable. Thus, it scares some investors away from purchasing with ETFs. However, the UBTI tax is only applicable if an ETF is engaging in business solely to generate income. Because most ETFs don't have such business operations (as they typically gain income through investments and other passive means), most ETFs are exempt from the UBTI tax. As long as this remains the case, the IRS will not impose this additional tax.

References

• MSN Money: Investing Answers
• Morningstar: Your ETF Tax Questions Answered