ETF Education: July 2019

July 01, 2019

ETF UNIVERSITY

Bond ETFs & Taxation

Bond ETFs differ from stock ETFs in some key ways. Some of these differences make investors lives’ easier while others just add more headache. That’s why we’ve broken down three of the most important things investors need to know about taxes on their bond ETFs.

Most Bond ETFs Are Taxed Like Stock ETFs
How an ETF is taxed depends on two things: what the fund holds, and how it is structured. Bond ETFs hold bonds, obviously, and bond taxation is relatively straightforward. If a bond generates taxable income during the year—which most bonds do—then that income will be taxed.

Open-ended bond ETFs and bond ETNs are taxed the same way—and it’s likely the same as for any other ETF, mutual fund or stock you own. Almost all bond ETFs are open-ended ETFs, and you aren’t taxed until you sell your shares. When you do, you owe capital gains tax on whatever profit you make. If you hold your shares for more than a year, you can use the lower long-term capital gains tax rate of 20%. If you held them for less than one year, then they’re taxed as ordinary income, the max rate of which is 39.6%.

However, taxation rules are somewhat different for a futures-based product like the SIT Rising Rate ETF (RISE), which is classified as a commodities pool and taxed as such.

Bond ETF Distributions Are Not Qualified Dividends
The IRS doesn’t just tax the profits you may have made from the sale of your bond ETF shares. It also taxes any distributions you may have received from your bond ETF.

Bond ETF interest payments are taxed as ordinary income. Bond ETFs make regular (usually monthly) coupon payments to shareholders; that interest is one of their biggest selling points. But this money is taxable. Though often called “dividends,” these interest payments aren’t considered qualified dividends by the IRS, meaning they don’t get the lower, qualified dividends tax rate. Instead, they’re taxed as ordinary income, with a max rate of 39.6% … that’s if they’re taxable at all (more on that below).

Bond ETFs pay capital gains more often than stock ETFs. Because bonds mature regularly, managers of bond ETFs often have to buy and sell securities over the course of the year to maintain a given duration or maturity range. That often means managers can’t take advantage of the same tax-loss harvesting strategies for bond ETFs as they can with stocks.

Ultimately that can result in an annual capital gains distribution. It’s worth noting that while the vast majority of ETFs each year don’t pay out capital gains to investors, the ones that do are usually bond ETFs.

That said, bond ETF capital gains distributions are usually very small. In many cases, these distributions are less than 1% of the ETF’s net asset value. For example, in 2014, the capital gains distribution for the iShares Core U.S. Aggregate Bond ETF (AGG) was just 0.08% of NAV. However, you’ll get higher figures for bond ETFs with constrained maturities—e.g., one- to three-year bond ETFs—since a large percentage of bonds in the portfolio exit the fund each year.

Interest Payments For Some Bond ETFs Are Tax-Free
Remember when we said that how an ETF is taxed depends on what it holds? That goes for the interest payments bond ETFs make every month to investors. Some funds can skip federal or even state taxes altogether, depending on the type of bonds they hold.

For example, U.S. Treasury ETFs are exempt from state and local income taxes but not federal taxes. Meanwhile, corporate bond ETFs see their interest payments taxed as ordinary income. And municipal bond ETFs are exempt from federal taxes and sometimes state and local taxes.

Also keep in mind the aforementioned exemptions only apply to interest payments. Bond ETF investors are still on the hook for any taxes owed on capital gains distributions, or profits accrued from the sale of their shares.

 


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