Paying Taxes on ETF Dividends

What You Need to Realize About Taxes on ETF Dividends

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As you know, one of the main benefits of ETFs is the tax advantage it holds over mutual funds. ETFs are more tax-efficient due to their construction and the way the IRS classifies them. Specifically, capital gain taxes are only realized on an ETF when the entire investment is sold whereas a mutual fund incurs capital taxes every time the assets in the fund are sold. However, when it comes to paying taxes on ETF dividends, the story is a little different.

And for those of you who are new to this concept, a dividend ETF consists of dividend-paying stocks and usually tracks a dividend index. The stocks in the fund or index are selected based on their dividend yield. Some ETFs apply a general dividend strategy that covers the market as a whole, or they can be segmented.

For example, there are some dividend ETFs that are based on the market capitalization of the included stocks, and there are some that are based on location such as a country-specific dividend ETF or an emerging market dividend ETF.

So now with that explanation, let's talk about the different types of ETF dividends...

Qualified ETF Dividends

There are two kinds of dividends that the stocks in an ETF may issue. Qualified dividends and unqualified dividends. In order for an ETF dividend to be taxed as qualified, the equity in the fund paying the dividend must be owned by the investor for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Also, it cannot be on the unqualified dividend list, and it must be paid by a U.S. or qualified foreign corporation.

The tax rate on qualified dividends is anywhere from 5% to 15%, depending on your income tax rate. If you have an income tax rate of 25% or higher, then your qualified dividend is taxed at 15%. If your income tax rate is less than 25%, then your qualified dividends are taxed at 5% So far, so good.

Unqualified ETF Dividends

Unqualified dividends are those payouts that do not meet the qualifications discussed above. In other words, they are dividends that the government does not consider true dividends. Some examples include dividends on money market accounts, dividends on short-term mutual fund capital gains, interest from your credit union, dividends in your IRA, and dividends from REITs (real estate investment trusts). In the case of unqualified dividends, these payouts are taxed at your normal income tax rate. So if you have unqualified dividends from the ETFs in your portfolio, then they will have a heavier tax burden than the normally qualified dividends from these securities.

Keeping track of your Dividends

Knowing the difference between qualified and unqualified dividends is very important in regard to ETFs. After you understand the concept, you will need to put that knowledge to use as you track the dividend payouts for all the stocks in your dividend ETFs (a spreadsheet may be helpful). Once you have it all figured out, you can fill out your tax forms correctly and file your return. Or you can do what most investors do and hire a good tax accountant. Hopefully, your gains will cover his fee.

As with any investment, it's important to know all the implications that are involved. So before you get started with ETFs, make sure you understand how they are going to affect your tax return.

And if you're looking for a dividend ETF, you've come to the right place. Dividend funds are gaining popularity due to their ability to create a revenue stream as well as a hedge against inflation and some types of risk. So if you're considering dividend ETFs for your trading strategy, then you will want to see some dividend ETFs in action. Well then, look no further than my List of Dividend ETFs