I was recently quoted in a DailyFinance.com piece discussing the hidden tax surprises in exchange-traded funds. You can find a segment of their article below, and I have bolded my quote in the story.
Index-based ETFs carry a big tax advantage for investors because there is very little turnover of the securities within the fund since the managers are simply matching investments to the actual index. Consequently, lower capital gains are passed onto the investor. By contrast, actively managed mutual funds can involve large turnover of the underlying assets and result in large capital gains realized by the investor. This is because the gains at the fund level must be passed on and taxed to the investor, explains Mike D'Avolio, Intuit's senior tax analyst. When an investor sells an ETF, a short or long term gain or loss is recognized and taxable just as it would be with the sale of an actual stock or bond. Investors in tax-deferred accounts such as IRAs don't need to worry about these tax advantages because they won't start paying taxes on those investments until they hit retirement age.
Such is the way of the world for "plain vanilla" ETFs. However, it's a bit more complex when it comes to exotic ETFs, those that trade in foreign currencies, highly leveraged securities, precious metals, commodities or clean technology, for example.
For starters, Uncle Sam looks at the underlying investment held by the exotic ETF to determine the tax consequences of the income earned. "Although this may sound basic, it's often the simplest information that gets overlooked. The way ETFs are taxed is dependent upon the underlying assets within the ETF," says Roni Deutch, CEO and founder of the Roni Deutch Tax Center.
For example, if ETF "A" holds stocks, bonds or mutual funds, any gain realized on the sale of ETF "A" would be taxed using the rates for capital gains (maximum of 15% for long-term gains). If ETF "B" holds precious metals, any gain realized on the sale of ETF "B" would be taxed using the rates for the sale of collectibles. Sales of collectibles are taxed as ordinary income for short-term gains (assets held less than a year) and 28% for long-term gains. That means that the income from the sale of ETF "A" is going to be taxed less than the income from the sale of ETF "B". "This higher tax rate may come as a shock to inventors in funds that buy and sell bullion, such as the IShares Silver Trust (SLV) and SPDR Gold (GLD)." Gains from most currency funds, are also taxed at ordinary income-tax rates.