Should five percent appear too small
Be thankful I don't take it all
'Cause I'm the taxman
Yeah, I'm the taxman
(If you drive a car, car) I'll tax the street
(If you try to sit, sit) I'll tax your seat
(If you get too cold, cold) I'll tax the heat
(If you take a walk, walk) I'll tax your feet
— “Taxman” by The Beatles
Taxes. Always a fun topic.
After being forced to pay a huge percentage of your annual income to the taxman, you are then taxed on your spending. Then when you successfully invest what little you have remaining, you get taxed on that too. And the taxman doesn’t just take your money against your will. He also makes it very complicated and time-consuming to figure out exactly how much you will be forced to give him. Such is the plight of an investor in our times.
What Is A K-1?
One of the more complex tax forms is a Schedule K-1 tax form. It is similar to a Form 1099, since it reports dividends, interest and other income from investments.
Most exchange-traded funds (ETFs) do not issue K-1s, but master limited partnerships (MLPs) and many commodity, currency and volatility ETFs that invest in futures contracts are legally structured as partnerships and must issue K-1s.
ETFs structured as partnerships do not typically pay federal taxes directly. Instead, they pass through their income and gains/losses directly to the individual investors or “partners”. They must send a K-1 to the investors each year detailing their financial interest in the partnership.
If you invest in an ETF that issues a K-1 tax form, you (or your tax preparer) are required to use the information on the form to fill out your tax return.
One K-1 ETF Positive
One positive of K-1 ETFs is they can generate lower taxes for short-term traders. Capital gains on K-1 ETFs are taxed at lower long-term capital gains rates for 60% of the gain and higher short-term capital gain rates for 40% of the gain, regardless of the holding period. Thus, instead of being taxed entirely at the higher short-term capital gains rate, short-term traders benefit from having 60% of their gains being taxed at the lower long-term capital gains rate.
K-1 ETF Negatives
One problem with K-1 forms is they typically arrive late in the tax season, usually around March 15, which can sometimes delay the filing of a tax return.
Another problem is you may have to pay taxes on income generated by the ETF, even if you didn’t sell the shares.
And if you own a K-1 ETF in a “tax-free” account such as an IRA, you may have to pay taxes on it! This can happen if there is income that is treated as Unrelated Business Taxable Income or UBTI. If the total UBTI for all investments in your IRA exceeds $1,000, then you will have to prepare Form 990-T for your IRA custodian for filing and pay taxes on that income. Many IRA custodians (including popular online brokers) will take care of this for you. Importantly, some K-1 ETFs have a history and goal of avoiding UBTI, such as those issued by ProShares, so it is wise to seek those out.
No K-1 ETFs
There are some commodity ETFs that do not issue K-1s. For example, a broad commodity no K-1 ETF is Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (ticker: PDBC), which is essentially the same as the K-1 issuing Invesco DB Commodity Index Tracking Fund (ticker: DBC).
A no K-1 oil ETF is ProShares K-1 Free Crude Oil Strategy ETF (ticker: OILK; red line in chart below), which performs similarly to the K-1 issuing United States Oil Fund (ticker: USO; black line in chart below), as shown below.
However, in some cases there are no alternatives, such as with currency, volatility and levered and inverse commodity ETFs.
Conclusion
Like taxes in general, K-1s can be an expensive hassle that harms your goal of accumulating wealth.
Our recommendations with regard to K-1 ETFs are:
- Try to find no-K1 ETF alternatives, whenever possible
- If you do invest in an ETF with a K-1, try to do so in a tax-free account such as an IRA; also, try to find ones that are unlikely to have UBTI
- If in doubt, as with all things tax-related, consult a professional tax advisor
- Lastly, encourage politicians to eliminate Schedule K-1 requirements; or better yet, encourage them to eliminate all taxes on savings and investments, which would create higher living standards for everyone