Best Of 2020: 3 Keys Of Bond ETF Taxation

Bond ETFs differ from stock ETFs in some key ways. Some of these differences make investors lives' easier—tax exemptions! yay!—while others just add more headache (more capital gains distributions! boo!).

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. (See: "The Definitive Guide To 2015 ETF Taxation"). 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, though 17 are exchange-traded notes. Either way, 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 percent. If you held them for less than one year, then they’re taxed as ordinary income, the max rate of which is 39.6 percent.

There's one exception: the Sit Rising Rate ETF (RISE).This ETF uses futures contracts and options on Treasurys, which technically makes it a commodities pool. That means:

• RISE's gains are taxed differently. Sixty percent of any gains will be taxed at a long-term capital gains rate of 20 percent. The remaining 40 percent are taxed at your ordinary income rate, no matter how long you held your shares. This comes out to a blended maximum capital gains rate of 27.84 percent.
• RISE is considered a "pass-through" investment, meaning gains must be "marked to market" at the end of the year and passed on to investors. ("Marked to market" means that, for tax purposes, its futures contracts will be treated as if the ETF had sold them.) You may be on the hook for taxes on those gains, regardless of whether you sold your shares.
• RISE generates a Schedule K-1 form. K-1s can be confusing and tedious for taxpayers not familiar with them.
• Although unlikely, RISE may also generate Unrelated Business Taxable Income (UBTI) that could be taxable in nontaxable accounts, like an IRA.

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 percent … that's if they're taxable at all (more on that below).

Bond ETFs pay capital gains more often than stock ETFs. 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. Bonds mature regularly, and managers can't take advantage of the same tax-loss harvesting strategies for bond ETFs as they can with stocks. (See "Why Are ETFs So Tax Efficient?") 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.

Bond ETF capital gains distributions are usually very small. In many cases, these distributions are less than 1 percent 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 | A-98) was just 0.08 percent of NAV. The Vanguard Total Bond Market ETF (BND | A-94) distributed gains of 0.26 percent. However, you will get higher figures for bond ETFs with constrained maturities—i.e., 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.

Here's how taxes break down depending on ETF type:
 

• U.S. Government Bond ETFs: Exempt from State Taxes
  Because U.S. Treasurys are tax-free at the state and local level, interest payments from sovereign bond ETFs that hold U.S. Treasurys are also exempt from state and local income taxes. They are subject to federal taxes, however.
• International Sovereign Bond ETFs: Not Exempt
  Interest payments from overseas bond ETFs are taxed as ordinary income.
• Corporate Bond ETFs: Not Exempt
  Interest payments from corporate bond ETFs are taxed as ordinary income.
• Municipal Bond ETFs: Exempt from Federal Taxes and Possibly State and Local Taxes
  Most muni bonds are free from federal income tax; they're often also tax-free to residents of the issuing state and/or city. So interest payments from a muni bond ETF are exempt at the federal level. They may also be exempt from local and state taxes, if you happen to live in the same state or city as the bonds the muni bond ETF holds.
• Broad Market Bond ETFs: Possibly Exempt
  The interest paid by some or all of the bonds in a broad-market bond ETF's portfolio may be tax-exempt. Check the fund's 1099-DIV form, where the type of income earned by each bond will be listed.

Also keep in mind 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.
 

Next: How To Build A Bond ETF Portfolio

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