The Cabot Dividend Investor portfolio currently holds three ETFs, one in each tier of our portfolio.
The Guggenheim Multi-Asset Income ETF (CVY) holds primarily common stocks, including MLPs and REITs, plus some CEFs and preferred stocks. The WisdomTree International SmallCap Dividend Fund (DLS) holds 100% international equities (stocks not listed on U.S. exchanges), and the PowerShares Preferred Portfolio (PGX) holds at least 80% fixed-rate preferred shares.
That means their distributions are coming from a variety of sources, including qualified stock dividends, non-qualified stock dividends, preferred stock dividends, MLP and CEF distributions, and possibly some fixed income distributions. That affects how you will pay taxes on the income, since ETF distributions are taxed based on their original source—i.e., how the fund earned them. So it’s important to know what your ETFs hold and what types of dividends those securities pay.
Guggenheim Multi-Asset Income ETF (CVY)
CVY holds primarily common stocks, but that includes MLPs and REITs, whose dividends are taxed differently. Plus the fund can own CEFs, preferred stocks and fixed income.
When ETF dividends come from common stock dividends, they’re taxed just as they would be if you owned the stock yourself. They can be eligible for the lower dividend tax rate if they’re paid by a qualified corporation. Most dividends paid by U.S. corporations will qualify for the lower rate, and some dividends paid by foreign corporations will too. Dividends from businesses organized in some structure other than a corporation—like REITs—will usually not be qualified. Last year CVY’s distribution was made up of 35% qualified dividends.
However, just as when you own an individual stock, you need to have held the ETF for over sixty days, including the ex-dividend date, in order to qualify for the lower dividend tax rate. In addition, the fund needs to have held the stock long enough for them to qualify for the lower rate too. So even if a fund only holds stocks of companies that pay qualified dividends, you may receive some non-qualified dividend income.
MLPs and REITs
In addition to dividend-paying corporations, CVY also holds stocks of companies organized in other structures, including MLPs and REITs. The fund passes on the tax status of distributions from these sources, so some of CVY’s distributions are usually classified as Return of Capital. The latest distribution was about 8% return of capital.
Note however that that’s not always the case with ETFs that hold MLPs. Most ETFs focused exclusively on MLPs, including the Alerian MLP ETF (AMLP), are organized as corporations and pay corporate income taxes on the MLP distributions they collect before passing them on to investors. That removes the tax burden for investors, but also the tax benefits. And the tax expense to the corporation is passed along to investors as part of the fund’s expense ratio.
Fixed Income
CVY can also hold fixed income securities including bonds. Like interest paid by individual bonds, the portion of the fund’s distribution that comes from these holdings will be taxed as ordinary income, and will not qualify for the lower dividend tax rate. (Income from municipal bonds will be exempt from income taxes and income from Treasury bonds will be exempt from state income taxes.)
WisdomTree International SmallCap Dividend Fund (DLS)
DLS restricts its holdings to common stock issued by foreign companies, so its distributions are made up entirely of common stock dividends, some of which will qualify for the lower dividend tax rate.
Foreign company stocks that are “readily tradable” on U.S. exchanges, including ADRs, are usually qualified for the lower rate. In addition, companies based in one of the 60 or so countries with which the U.S. has a “comprehensive income tax treaty,” including Australia, Canada, China, France, India, Israel, Japan, South Africa, Switzerland and the United Kingdom, are usually qualified dividend payers.
Most of the WisdomTree International SmallCap Dividend Fund’s holdings are listed in countries on the tax treaty list (the most significant exception is Singapore, where 4.24% of the fund’s holdings are based), so a large portion of their dividends should qualify for the lower tax rate.
Of course, the holding period rules still apply to both you and the fund.
PowerShares Preferred Portfolio (PGX)
PGX’s distributions come from preferred stock dividends, which can be qualified or unqualified. In general, if a company pays qualified dividends on its common stock, its preferred stock dividends will be qualified as well. Preferreds issued by tax-advantaged entities like REITs will not pay qualified dividends (qualified dividends are only paid by companies that have taxable income).
Other ETFs
In general, looking at the source of ETF distributions should tell you how those distributions will be taxed, as with our three portfolio holdings. However, some ETFs are subject to additional rules. Here are a few points to keep in mind:
• Sometimes funds will distribute capital gains generated by price appreciation and sale of assets—often at the end of the year. These distributions will be taxed at either long-term or short-term capital gains rates, depending on how long you have held the ETF and how long the ETF held the assets.
• ETFs that use leverage and ETFs that use derivatives (including most inverse ETFs) often generate significant capital gains throughout the year because of how the IRS treats gains from derivatives.
• Income from precious metals ETFs can be taxed at the collectibles tax rate, which maxes out at 31.8%. Income from commodity and currency ETFs may also be subject to different tax rates.
• If you sell an ETF at a profit, you will owe capital gains taxes. Capital gains rates for stock and bond ETFs are the same as for individual stocks (23.8% maximum for long-term gains and your income tax rate for short-term gains). Capital gains from precious metal ETFs and some currency and commodity ETPs (exchange-traded products) may be taxed at higher rates.
At the end of the year, you should receive a 1099-DIV form from each ETF you own detailing the sources and tax rates of their distributions for that year.
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