Exchange-traded funds (ETFs) are a type of security that tracks a commodity, group of assets or index and trades like a stock on an exchange. Unlike a mutual fund, which settles at the end of the day, the price of an ETF can fluctuate throughout the day as shares are bought and sold. The primary advantages that ETFs offer over traditional mutual funds include lower minimum investments, lower management fees, increased liquidity and increased tax efficiency, as there are typically fewer taxable turnover events within these funds.
Certain ETFs may focus on a specific sector, such as energy, finance or tech. Other ETFs follow an index, such as the Dow Jones Industrial Average, NASDAQ or the Standard & Poor 500 Index. Movements in the underlying index or sector influence the direction of ETF share value.
In terms of the types of assets an ETF can hold, they may include shares of stock, bonds, oil futures, precious metals or foreign currency. If an ETF includes dividend-paying stocks, the dividends can be paid out to investors as cash or reinvested to purchase additional ETF shares.
These dividends are taxable, as are any gains associated with the sale of ETF shares. With dividends, the taxation is based on whether the investor receives ordinary or qualified dividends. Ordinary dividends are taxed as ordinary income, while qualified dividends are subject to capital-gains tax rates. Earnings from the sale of an ETF are taxed as capital gains.
Whether investors pay short- or long-term capital gains taxes on profits from a sale is determined by how long an investor holds the ETF shares. Generally, investments held for less than one year are subject to the higher short-term capital gains rate. Investments held for longer than one year are subject to the more favorable long-term capital gains rate.