Exchange-traded funds (ETFs) are taxed in the same way as their underlying assets would be taxed. Therefore, if an ETF has all stock holdings, it gets taxed just as the sale of those stocks would be taxed. If you hold an ETF for more than a year, then you will pay capital gains tax. If you hold it for less than one year, any profits will be treated as ordinary income. Although the required taxes are usually similar, there are extenuating circumstances for certain types of ETFs and their dividends, provided they meet certain criteria.
- Some but not all ETFs will pay dividends to their shareholders.
- Not all ETF dividends are taxed the same and are broken down into qualified and unqualified dividends.
- Qualified dividends are taxed between 0% and 20%.
- Unqualified dividends are taxed much higher, from 10% to 37%.
- High-earners will pay additional tax on dividends, but only if they make a substantial income.
Qualified vs. Unqualified Dividends
Qualified dividends are dividends that are taxed at a lower capital gains tax rate than unqualified, or ordinary, dividends. Depending on the tax bracket the investor finds themself in, qualified dividends can be taxed anywhere from 0% to 20%.
The lower capital gains tax rate that is applied to qualified dividends comes as a result of that dividend meeting special requirements put in place by the Internal Revenue Service (IRS). The requirements are that the dividend must be paid by a U.S. company or a qualifying foreign company, that the dividends have not been previously excluded by the IRS as a qualified dividend, and that the holding period has been met.
Unqualified dividends are those that are taxed at the federal income tax rate. This can range anywhere from 10% to 37% for tax years 2021 and 2022. Most dividends fall into this category as they are considered unqualified by default, only becoming qualified if the above criteria are pursued and met.
ETF Dividend Taxation
Let’s first establish that ETFs holding stocks usually pay dividends quarterly or once a year, and ETFs holding bonds usually pay interest monthly. If you’re investing in an ETF that holds stocks, then you want to make sure it’s paying qualified dividends.
To receive a qualified dividend, you must hold an ETF for more than 60 days during the 121-day period before the dividend is issued, known as the ex-dividend date. The current tax rates on qualified dividends are 0%, 15%, and 20%, depending on your filing status and tax bracket.
If you are in the lower tax brackets, you could very well pay 0% taxes on qualified ETF dividends. Granted, you would still pay tax when you sold the ETF itself, but would not pay taxes as long as you satisfy the qualified dividend requirements for holding mentioned above.
For single taxpayers, this threshold is $41,675 for 2022. As long as your modified adjusted gross income (MAGI) is below this level, you would pay no taxes on qualified dividends. The next dividend rate is 15% for incomes between $41,675 and $459,750. Individuals who make more will pay 20% on their qualified dividends.
If you hold an ETF for fewer than 60 days, dividends will be taxed as ordinary income. All dividend income will be reported on Form 1099-DIV. This of course only applies to the dividend. All sales of an ETF under one year will result in a short-term capital gains tax, which is significantly higher than the tax you would pay if you would have held it for a year or more.
Individuals who are in the highest tax brackets will be required to pay an additional 3.8% Net Investment Income Tax (NIIT). For single filers, this threshold is $200,000. Married filing jointly is $250,000, and filing separately is $150,000. The income amounts that trigger the NII tax are based on the filing person’s modified adjusted gross income.
ETFs only trigger a taxable event when they are sold. This is different from a mutual fund, and it creates tax advantages that favor ETF investing.
Some investors find that having dividend-paying ETFs can add a solid core to their portfolio. It can offer tax advantages as well as provide a stream of steady income in the form of qualified dividends. One of the larger high dividend ETFs is the SPDR Portfolio S&P 500 High Dividend ETF (SPYD).
SPDR Portfolio S&P 500 High Dividend ETF (SPYD)
- Performance Over One-Year: 29.2%
- Expense Ratio: 0.07%
- Annual Dividend Yield: 4.88%
- Assets Under Management: $5.4 billion
- Inception Date: Oct. 21, 2015
- Issuer: State Street
SPYD aims to track the High Dividend Index of the S&P 500. This index measures the 80 highest-dividend-yielding companies in the index. The ETF pays a healthy dividend which is derived from mostly large-cap stocks in the utilities, financials, and real estate sectors.
Schwab US Dividend Equity ETF (SCHD)
- Performance Over One-Year: 17.87%
- Expense Ratio: 0.06%
- Annual Dividend Yield: 2.92%
- Assets Under Management: $33.9 billion
- Inception Date: Oct. 20, 2011
- Issuer: Schwab Asset Management
The Schwab U.S. Dividend Equity ETF tracks the total return of the Dow Jones U.S. Dividend 100 Index. It is similar to SPYD above as it is a relatively straightforward, low-cost ETF designed to offer investors broad exposure while providing a quarterly dividend payment. The top holdings in SCHD are Pfizer Inc., Texas Instrument Inc., and Home Depot Inc. The ETF is heavy in financials and tech, followed by consumer staples and industrials, and is comprised of 103 holdings.
What Are Dividend ETFs?
Dividend ETFs can either be ETFs that tracks a dividend-paying index or an ETF that pays a dividend to shareholders. Both are valuable long-term investing products and many investors use dividend ETFs as the core of their portfolio.
How Are You Taxed on ETFs?
Tax rates on ETFs themselves are treated the same way as holding common stock. ETFs held less than a year before they are sold are taxed at the short-term capital gains tax rate. This is much higher than if you were to hold for a year or longer.
Do You Pay Taxes on ETF Dividends?
In some cases, you could be exempt from paying taxes on ETF dividends. You would need to meet specific income criteria, as well as be receiving dividends deemed qualified by the IRS. in most cases, people will be paying taxes on their ETF dividends, which can range from 0% up to around 40%.
The Bottom Line
Tax obligations for ETF dividends depend on whether or not they’re qualified or unqualified dividends. If they’re unqualified dividends, they will be taxed at your normal income rate. If they’re qualified dividends, they will be taxed between 0% and 20%. Discussing an ETF dividend strategy is best done with a qualified investment advisor and accountant if you are not clear on the complexities involving your income and tax brackets.