How Are ETF Dividends Taxed?

One of the primary advantages of investing in ETFs is the potential for receiving dividends. However, it's important to understand how ETF dividends are taxed before making investment decisions. 

How Are ETF Dividends Taxed? 

How ETF dividends are taxed depends primarily on the types of dividends that are distributed from the fund. ETFs can distribute dividends in two forms: qualified and nonqualified. More specifically, the tax treatment of an ETF's dividend depends on the underlying securities held by the fund and the length of time the investor held the ETF. 

Qualified dividends are taxed at lower capital gains tax rates, whereas non-qualified dividends are taxed at the investor's ordinary income tax rate. 

Here are the basics on how qualified and nonqualified ETF dividends are taxed: 

Taxation on Qualified Dividends  

Qualified dividends are typically paid out by ETFs that hold U.S. stocks and meet specific criteria set by the Internal Revenue Service (IRS). To qualify for lower tax rates, the ETF must hold the underlying stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. In addition, the stock must be issued by a U.S. corporation or a qualified foreign corporation. 

Qualified dividends are taxed at the long-term capital gains tax rate, which is generally lower than the ordinary income tax rate. For most investors, this rate is 15%, although it can be as low as 0% or as high as 20% depending on the investor's income level. It's worth noting that investors must hold the ETF shares for at least 61 days during the 121-day period that begins 60 days before the ex-dividend date to be eligible for the lower tax rate. 

Taxation on Nonqualified Dividends 

Nonqualified dividends are taxed at the investor's ordinary income tax rate, which can be significantly higher than the capital gains tax rate. Nonqualified dividends are typically paid out by ETFs that hold securities such as real estate investment trusts (REITs), foreign stocks or bonds. 

If an investor sells their ETF shares before holding them for at least 61 days, any dividends received will be considered nonqualified and subject to the ordinary income tax rate. Additionally, if an ETF fails to meet the IRS' criteria for qualified dividends, any dividends paid will also be considered nonqualified. 

Examples of High Dividend ETFs 

Here are the largest high dividend yield ETFs, as measured by assets under management through March 14, 2023: 

Taxation on Dividend ETFs Held in a Retirement Account 

Investors should keep in mind that ETF dividends are not taxed while held in a retirement account, such as an individual retirement account (IRA) or a 401(k). This is because investments held in a qualified retirement account grow tax deferred. Depending on the contribution type, withdrawals from retirement accounts may be taxed as income. 

For example, money in a traditional IRA grows tax-deferred, which means that any interest, dividends or capital gains earned within the account are not taxed until the money is withdrawn. When the investor withdraws money from their traditional IRA in retirement, the withdrawals are subject to income tax at the investor's ordinary income tax rate.  

However, the money in a Roth IRA grows tax-free, which means that any interest, dividends or capital gains earned within the account are not taxed, and qualified withdrawals are also tax-free. To make qualified withdrawals from a Roth IRA, the account must be open for at least five years, and the investor must be at least 59 ½ years old or meet other criteria, such as a disability or a first-time home purchase. 

Certain nonqualified withdrawals from a traditional IRA or IRA, such as those made prior to age 59 ½, may be subject to income tax and a 10% early withdrawal penalty. 

Bottom Line 

In summary, ETF dividends are taxed differently depending on whether they are qualified or nonqualified. Qualified dividends are subject to lower capital gains tax rates, while nonqualified dividends are subject to the investor's ordinary income tax rate. Investors should consider the tax implications of ETF dividends before making investment decisions, as it can have a significant impact on their after-tax returns.