Earning qualified dividends will significantly reduce your income tax bill compared to earning dividends that are fully taxable. The characteristics -- and tax consequences -- of dividends paid by a particular exchange traded fund depend on the type of securities owned by the fund.
Internal Revenue Service rules state that dividends from U.S. and foreign corporations qualify for lower income tax rates for investors who earn the dividends. Qualified dividends are dividends earned from owning stock. The tax status of dividends paid by an ETF is determined by the type of securities held by the fund. To pay qualified dividends, an ETF must own stock paying qualified dividends. Bonds pay interest so a bond fund does not pay qualified dividends.
Types of Bond ETFs
The tax nature of a bond ETF depends on the type of bonds in which the ETF invests. The types of bond ETFs include Treasury bond funds, government bond funds, foreign bond funds, corporate bond funds and municipal bond funds. The dividends paid by each type of fund will carry the tax consequences of the type bonds owned in the fund. As non-qualified dividends, the income earned from a bond ETF will not qualify for the lower, qualified dividends tax rate.
Bond ETF Taxes
The tax rate for dividends from a corporate or international bond ETF will be at your marginal income tax rate. The dividends from a municipal bond ETF will be exempt from income taxes. The interest from Treasury bonds is exempt from state income taxes, so dividends from a Treasury bond ETF will be taxable at your federal income tax bracket and exempt from state income taxes. A bond ETF holding different types of bonds will list the different types of income earned on the 1099-DIV form you will receive from the fund.
Reducing the Tax Bite From Bond ETF Dividends
There are several strategies to reduce the tax obligation from your bond ETF dividends. Investing in municipal bond ETFs turns the dividends into tax-free income. You should compare the after tax yield of taxable ETFs to the yield paid by municipal bond ETFs. Buy your taxable bond ETFs through a tax-advantaged account such as an Individual Retirement Account or Roth IRA. If you want to own government bond ETF shares, buy a fund that invests only in Treasury securities. Treasury interest is exempt from state income taxes, while other types of government bond interest are taxable at both the federal and state levels.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.