Tax Season ETF Guide

NEW YORK ( TheStreet) -- One of the highlights of ETFs that has helped gather popularity for the investment vehicle is their tax efficiency in comparison to mutual funds. Passive management, trading on the secondary market and in-kind redemption by authorized participants are three ways that ETFs can beat mutual funds.

However, that doesn't mean investors can buy ETFs without concern for taxes. There are different types of ETFs, with different tax implications, and investors should be informed before they invest.

This article will provide an overview of how taxes are typically decided for different classes of ETFs in order to give investors a better idea of what to expect. From physically backed commodity ETFs such as SPDR Gold Shares ( GLD) and standard equity funds such as SPDR S&P 500 ( SPY), to more complicated futures-based funds such as United States Natural Gas ( UNG), this guide will give you the ETF-related tax information you need to make better informed investments.

First off, the plain vanilla ETFs that track a basket of equities, such as the popular PowerShares QQQ ( QQQQ) or iShares MSCI Emerging Markets Index ( EEM), are taxed the same way that gains are taxed for equities of individual companies. For example, the capital gains taxes on an investment in Bank of America ( BAC) will be the same as the capital gains taxes for an investment in Financial Select Sector SPDR ( XLF), of which BAC is the largest holding.

This is true of ETFs that track baskets of companies traded on foreign stock exchanges as well.

When an equity ETF makes dividend distributions, these are also taxed in the same way as dividends from a single equity, and investors receive a 1099 form.

Not all ETFs track equities though, and providing easy access to commodities as investments has been a format that has made many such funds popular with investors.

In this fund category, investors should be aware that there are different tax treatments between ETFs that physically invest in a commodity and ETFs that invest in the futures of a commodity.

ETFs that invest in the futures of a commodity, such as United States Oil ( USO), will have 60% of gains taxed at the long-term capital gains rate for an investor's income class and will have 40% of gains taxed at the short-term capital gains rate. This will be the case regardless of how long the ETF is held.

Most ETFs that track single currencies or baskets of currencies will also be taxed in this same way as the commodity futures funds.

On the other hand, commodity ETFs that hold physical quantities of the commodity being tracked, such as iShares Silver Trust ( SLV) will be taxed as collectibles. The tax rate on gains from this sort of investment is typically 28% versus 15% for equity ETFs.

Another way of investing in commodities is through exchange traded notes, and these differ from physically backed commodity ETFs in that most do not make taxable distributions and are taxed based on the gains made at the time they are sold by investors. There also may be taxes though associated with the redemption or maturity of the ETN.

One reason that investors may prefer a commodity ETN to an ETF is because the ETFs send K-1 forms, which can be a headache for do-it-yourself investors. Although an ETN has the added risk of the credit rating of the company behind the debt note, this tax difference may be worth it for some investors. A popular equity ETN is the JPMorgan Alerian MLP Index ETN ( AMJ), which tracks a basket of K-1-issuing master limited partnerships in the energy space. The ETN makes quarterly dividend payments and they're reported on the standard 1099 form.

Another popular class of fund is fixed income ETFs. Investors should take note that the income distributions from these funds are taxed as ordinary income as opposed to taxed as dividends.

Finally, investors should be aware that these are just general guidelines about how some of the more popular classes of different ETFs are taxed. For absolute certainty in tax season, investors should carefully read the prospectuses of their ETF holdings or consult with a tax or investment adviser.

At the time of publication, Dion owned IAU and QQQQ.

Don Dion is president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.