ETF Taxation (US)

The four moving parts

1. Dividends. Fund distributions are reported by category on Form 1099-DIV. Qualified dividends, which most broad US equity ETF distributions are, receive long-term capital-gains rates. Non-qualified (ordinary) dividends arise from REITs, bond funds' interest, some foreign sources and short holding periods, and are taxed at your marginal rate. Bond ETF distributions are, in substance, interest: ordinary income, with the important exceptions of Treasury income (exempt from state and local tax, meaningful in high-tax states) and municipal bond funds (federal-exempt, sometimes state-exempt in-state).

2. Gains on sale. Sell above your cost basis and you have a capital gain: long-term if held more than one year (preferential rates), short-term otherwise (ordinary rates). Losses offset gains, then up to a limited amount of ordinary income annually, with the remainder carried forward indefinitely: a genuinely valuable asset, discussed below.

3. Capital gains distributions from the fund. The famous US ETF advantage: because redemptions happen in kind, equity index ETFs rarely realize gains internally, so they rarely distribute them (Chapter 54 explains the mechanism, and where it fails: bond ETFs with cash redemptions, some active and commodity products). Compare with mutual funds, where distributions triggered by other shareholders' exits are routine. This is the structural reason ETFs are the right taxable-account vehicle in the US.

4. The Net Investment Income Tax and other surtaxes layer on above income thresholds: another maintained-figure item.

The levers you control

Lot selection. Every purchase creates a tax lot with its own basis and date. Brokers default to FIFO or average cost; specific identification lets you choose which shares to sell: the highest-basis lots to minimize gains, or specific lots to manage the one-year boundary. Set the default at your broker before you ever sell; correcting afterwards is painful.

Tax-loss harvesting. Sell a position trading below basis, realize the loss, and immediately reinvest in a similar but not substantially identical fund to stay invested. The loss offsets current or future gains; the position keeps its market exposure. Two guardrails:

• The wash-sale rule disallows the loss if you buy a substantially identical security within 30 days before or after: including in your IRA, and including through automatic reinvestment you forgot to switch off. The standard practice is to swap between funds tracking different indices (an S&P 500 fund for a total-market fund, for instance); the IRS has not blessed a bright line, so conservative practice avoids swapping between two funds on the identical index.
• Harvesting lowers your basis, deferring rather than erasing tax: valuable because deferral compounds and because rates may be lower later, but not free money.

Asset location. Chapter 28's matrix, restated as tax logic: ordinary-income assets (bond funds, REITs) belong in tax-deferred accounts; broad equity ETFs are already tax-gentle and tolerate taxable space; the Roth ideally holds the highest-growth assets. Plus Chapter 51's US-specific twist: international equity funds belong in taxable accounts, where the foreign tax credit for withheld dividends is usable, rather than in IRAs where it evaporates.

Charitable donation of appreciated shares. Donating long-held appreciated ETF shares directly to a qualified charity (or donor-advised fund) can avoid the capital-gains tax entirely while providing a deduction at fair value, subject to limits: the most tax-efficient charitable route available to most investors, and one that pairs naturally with a portfolio full of low-basis index shares.

The step-up at death. Under current law, heirs receive a basis step-up to date-of-death value, erasing unrealized gains for tax purposes. This is why a long-term holder's default should often be don't sell: harvest losses, donate appreciated lots, spend from elsewhere, and let the largest gains pass at the step-up.

Two structures that surprise people

• Commodity and currency products often use different tax regimes: physically-backed metal trusts are taxed as collectibles (a higher long-term rate ceiling, Chapter 23); futures-based partnerships issue K-1s with mark-to-market treatment and blended rates; some currency and note structures have their own rules. Check the tax section of the prospectus (Chapter 25) before buying anything that isn't a plain equity or bond fund.
• Foreign-domiciled funds are effectively off-limits to US taxpayers via the PFIC rules, whose punitive interest-and-ordinary-income treatment makes them uneconomic. Buy US-domiciled funds (Chapter 50's mirror rule).

A worked example

Daniel, taxable account, holds a total-market ETF (large gain) and an international ETF (down 12% after a bad year).

• Harvest: sells the international position at a loss, immediately buys a different international index fund (developed-markets index rather than the all-world one he held). Market exposure unbroken; the realized loss offsets a gain he took earlier in the year, and the remainder carries forward.
• Wash-sale check: his IRA holds no international fund, and he had already switched off dividend reinvestment in that position: two of the three classic traps disarmed deliberately.
• Location: he notes the international fund is correctly in taxable (foreign tax credit usable) and moves his bond fund purchases into his 401(k) going forward.
• The unsold winner: the total-market position stays put. When he gives to charity in December, he donates the oldest, lowest-basis shares rather than cash, and the gain is never taxed.

Nothing here required predicting markets. All of it required knowing the order of operations: which is what a tax chapter is for.