Calculating the decrease in effective yield from turnover rate of ETF

Question

I want to invest in a high dividend ETF. Two ETF's that I'm comparing are:

SCHD

• Distribution Yield TTM: 2.57%
• SEC Yield (30 day): 2.92%
• Portfolio Turnover: 15%
• Net Expense Ratio: 0.07%
• 1 Year tax cost ratio: 1.76%

SPYD

• Distribution Yield TTM: 3.86%
• SEC Yield: 4.09%
• Portfolio Turnover: 40%
• Net Expense Ratio: 0.07%
• 1 Year tax cost ratio: 1.76%

SPYD pays higher dividends, but it also has a higher turnover rate. When stocks are turned over they may have capital gains. Capital gains incur taxes. From my understanding, the extra dividends I get from SPYD would by offset by the more taxes I pay on the turnover. However, both SCHD and SPYD seemed to be paying the same taxes for the past 1 year.

The Morningstar Tax Cost Ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.

Can you explain why I would pay the same taxes when the turnover rates are so different on these two ETF's? At the end of the day, I want to choose the ETF that gives me the best dividend yield net taxes.

Answer 1

With a mutual fund, you pay tax on the turnover within the fund as if you had made sales yourself. Not so with an ETF. For tax purposes, an ETF is treated like a single security, rather than a portfolio you manage. Therefore under normal circumstances, ETF turnover does not affect your taxes. You will owe capital gains tax only on the appreciation in the ETF price, not the appreciation of the stocks it holds. And you will only have to pay the ETF capital gains when you sell the ETF.

Because of this tax treatment, only the dividends paid by the ETF are relevant to the Tax Cost Ratio. Now that you understand ETF taxation, you will likely not want to look at the Morningstar Tax Cost Ratio. It was designed for mutual funds and isn't a very useful measure for ETFs.

=== EDIT ===

I took a stab at explaining why the two funds have different dividend yields and yet have the same Tax Cost Ratio. Looking at the details of their calculation, I think my guess was wrong, so I will omit it. I don't know why they have the same Tax Cost Ratio. Would be interested in ideas from other contributors.