The current draft of President Joe Biden’s tax proposal features several changes to Exchange Traded Funds (ETF), including in-kind trading and increasing the rate of qualified dividends. This PYA Insight looks at the proposal and breaks down these changes and any related tax consequences. Please note that as of publication, Congress has not yet voted on the proposed tax plan.
What Is an ETF:
An ETF is a type of security that tracks an index, sector, commodity, or other asset. It is composed of a portfolio of stocks and/or bonds that can be purchased or sold on a stock exchange, in the same manner as a mutual fund. Trends show many investors are moving away from mutual funds and investing more in ETFs. From 2019-2020, there was a 55% increase in money invested in ETFs—even more reason to show the current tax implications of an ETF, and the proposed legislation’s tax impact on an ETF (as of article publication).
Tax Advantages of an ETF:
Mutual funds must sell securities to cover shareholder redemptions. This can result in selling appreciated securities, which trigger capital gains in the resulting tax bill for the continuing mutual fund shareholders. Capital gain distributions can occur even during periods when the value of the fund shares is going down. That results in the worst-case scenario of tax bills coming due while shares values are dropping.
In contrast, ETFs do not have to sell assets to cover shareholder redemptions, because there are none. When ETF investors redeem their shares, they are simply sold to the next investor in line—like stocks—and there are no tax consequences for the continuing shareholders. This is referred to as an in-kind trade, which is the deferment of taxes until you sell your position.
Proposed Tax Legislation: Senator Ron Wyden is calling for an end to this deferment in hopes of raising an extra $200 billion over the next 10 years. His push for an end to in-kind trading has been met with great pushback from lobbying groups within the finance industry, and many experts are saying this is unlikely to make it into the final draft of the proposal.
Tax Consequences of an ETF:
Since the sale of an ETF is the same result as a stock sale, shareholders may now have a capital gain to worry about. This section breaks down the risks associated with selling a position in an ETF, focusing on the “garden variety ETF.” This means the ETF does not fall into the following categories: international emerging market ETF, any form of derivative ETF, or a commodity ETF. Since these types of ETFs are more difficult in nature and have more complex tax consequences, this article will only focus on ETFs most investors have in their portfolios.
ETFs that hold dividend-paying stocks pay those out, often quarterly. Dividends designated by an ETF as qualified dividends are taxed at the same federal rates as net long-term capital gains: currently 0%, 15%, or 20%, depending on your income level.
Dividends designated by the ETF as nonqualified dividends are taxed at higher ordinary income rates. At higher income levels, nonqualified dividends can be hit with the 3.8% net investment income tax (NIIT) on top of the “regular” federal income tax rate.
Proposed Tax Legislation: The proposed tax plan would increase the maximum federal rate on qualified dividends to 39.6%. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%).
Starting in 2022, the proposed plan would raise the top individual federal income tax rate on non-qualified dividends back to 39.6%, the top rate that was in effect before the Tax Cuts and Jobs Act lowered it to the current 37%. This proposed rate increase would affect singles with taxable income above $452,700, married joint-filing couples with taxable income above $509,300, and heads of household with taxable income above $481,000. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%).
If you hold garden-variety ETF shares in a taxable account for one year or less and sell for a profit, you have a short-term capital gain. Net short-term capital gains are taxed at higher ordinary income rates, just like salary and interest income.
Proposed Tax Legislation: As noted above, starting in 2022, the proposed plan would raise the top federal income-tax rate back to 39.6% on net short-term capital gains recognized by individuals.
If you hold garden-variety ETF shares in a taxable account for more than one year and sell for a profit, the federal long-term capital gains tax rates for individuals apply.
Proposed Tax Legislation: The proposed plan would increase the maximum federal rate on net long-term capital gains to 39.6% for gains recognized after a yet-to-be-determined date in April of 2022 (as the plan has not yet been voted on, this is a projected date). After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%). However, the proposed rate increase would only apply to taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000, if “married filing separately” status is used.
Short-Term and Long-Term Losses
Losses from selling garden-variety ETF shares are treated as capital losses. You can deduct capital losses against: (1) capital gains from other sources and/or (2) up to $3,000 of ordinary income from salary, self-employment, interest, and so forth ($1,500 if you used married filing separately status). Any remaining capital losses are carried forward to the following tax year and are subject to the same rules in that year.
If you have questions about ETFs or other potential changes in Biden’s tax proposal, or if you would like assistance with any matter involving audit and assurance, business advisory, or regulatory compliance, one of our executive contacts would be happy to assist. You may email them below, or call (800) 270-9629.