Story Highlights

Taxes on short-term gains are 35% for most ETFs Taxes on long-term gains on some currency ETFs can also be 35% The best way to make money from ETFs: Dont trade them frequently

Did you trade exchange traded funds last year? Are you doing your taxes now? Might you, by chance, be reading this from your window ledge? Well, no wonder.

Exchange traded funds are mutual funds whose shares, unlike those of garden-variety funds, trade on the stock exchanges, all day, every day. Trading ETFs has its own risks, like losing lots of money in a short period of time.

To add insult to injury, the government taxes ETF gains at different rates, depending on the kind of things they invest in, and the type of ETF they are. And if you rue the time you spent trading ETFs, you’re going to really regret the time figuring out your gains and losses.

The main advantage of ETFs is that you can trade them all day long. Fund companies and brokerages have made it even easier to do so. You can now trade many ETFs commission-free at Charles Schwab, TD Ameritrade, Fidelity, Vanguard and elsewhere.

If you’ve ever jumped off your roof with an umbrella, you know that just because you can do things doesn’t mean you should. Some people make money trading ETFs, but many more lose early and often. If you’re saving for a long-term goal, such as retirement, you’re better off with more sedate investment approaches.

And trading ETFs in a taxable account can mean some real headaches. (If you trade in a tax-advantaged retirement account, such as an IRA, of course, you don’t have to worry about the tax implications.) Under tax law, your ETF is taxed according to what it invests in.

If you sell a stock ETF, for example, your capital gain is taxed at the same rate as if you sold IBM or Intel stock for a profit. Long-term gains — those held for one year or more — are taxed at 15%, while short-term gains are taxed at your ordinary income tax rate, a maximum 35%.

Let’s say you sold your shares of the SPDR S&P 500 ETF, which tracks the Standard & Poor’s 500-stock index. You made a $1,000 long-term gain. Your tax: 15%, or $150.

But let’s say you sold shares of SPDR Gold Shares, another popular ETF, which invests directly in gold bullion. Your long-term gain: $1,000. Your tax: 28%, or $280. Why the difference? Because gold bullion is considered a collectible in the eyes of the IRS, and long-term collectible gains are taxed at 28%.

Other ETFs are taxed at yet a different rate. Many ETFs that invest in more mundane commodities — oil, gas, timber, iron — don’t actually have log flumes or warehouses full of scrap metal. Instead, they invest in futures contracts for the commodities involved. Naturally, those are taxed at a different rate than other ETFs.

Consider iShares S&P GSCI Commodity-Indexed Trust, which invests in a broad basket of commodities via futures contracts. Because the fund invests in futures, your gains are taxed at the same rate as futures contracts: 23%, whether the gains are long-term or short-term. (In case you’re wondering, the rate is based on a blend of 60% short-term gains and 40% long-term gains.)

Also, because the Trust is a limited partnership, you’ll get an IRS Form K-1 in the mail. But you’ll probably get it later than you’ll get your 1099, which is what you get from your brokerage. iShares S&P GSCI Commodity-Indexed Trust expects to make its K-1 forms available March 5. You can have an instance where someone gets their taxes done early, sends it off, and then gets a K-1 in the mail, says Dennis Hudachek, ETF analyst for IndexUniverse.com. That can be annoying.

And how. A bigger annoyance can be taxes on currency ETFs. Here again, the taxation of gains depends on what the ETF buys and sells. If it uses futures contracts, you get the 23% rate for short-term or long-term gains.

But if the fund actually holds foreign currency — as the CurrencyShares ETFs do — then your tax rate is your income tax rate no matter how long you hold them.

A few currency funds, such as those sponsored by WisdomTree and Pimco, invest in short-term foreign securities, thereby giving investors exposure to foreign currencies. Gains from these funds are taxed at the same rates as stock mutual funds: 35% for short-term gains, and 15% for long-term gains.

How do you know what rate to apply? Call your brokerage or visit the company’s website. In some cases, the tax treatment is deep within the fund’s prospectus, and searching for that will just make a good day better.

If there’s some good news in this morass of tax code, it’s that losses can reduce any capital gains you have. Let’s say you have $10,000 in losses and $6,000 in gains. You can use $6,000 in losses to eliminate taxes on your gains. You can deduct another $3,000 in losses from your income. And you can carry forward the remaining $1,000 in losses to the 2013 tax year.

But the best advice is this: If you really must trade ETFs, keep very good records, even though your brokerage should be able to give you information on your gains and losses. Try to sell losing positions before the end of the year, so you can get the tax benefits from losses.

ETFs can be very tax-efficient if you resist the urge to trade them. And they often have very low annual costs. They’re not inherently bad investments. Just remember: Trading ETFs can be a path to riches. Just not yours.