If you're interested in investing in gold but don't want to deal with the hassle of storing physical gold or the high fees that can be associated with buying and selling it, then a gold ETF might be a great option for you.
In this article, we'll explain how a gold ETF works and why it could be a smart choice for your investment portfolio.
How Does a Gold ETF Work?
A gold ETF is a type of investment fund that holds gold assets, such as bullion or futures contracts, and is traded on a stock exchange. The price of the ETF is directly linked to the price of gold, and investors can buy and sell shares of the ETF on the stock exchange just like they would with any other stock.
For example, if the price of gold increases by 1%, the value of the ETF should also increase by approximately 1%. Similarly, if the price of gold decreases, the value of the ETF should decrease as well.
When an investor buys shares of a gold ETF, they are essentially buying a portion of the gold held by the fund. This means that investors do not own physical gold, but instead own a share of the ETF that represents a certain amount of gold. For example, if an investor buys one share of a gold ETF that holds 10 ounces of gold, that investor effectively owns 1/10 of an ounce of gold.
The largest gold ETF is the SPDR Gold Trust (GLD), with $56.07 billion in assets as of March 15, 2023.
Physical Gold vs. Gold ETFs: Benefits and Risks
Physical gold is a direct investment and it is actual gold that you can hold in your hand, such as coins, bars or jewelry. However, gold ETFs are an indirect investment because investors do not take ownership of gold itself. Instead, they buy shares of the ETF, which may hold gold, or it may use futures contracts to track the price of gold.
Benefits of Physical Gold
- Tangible asset: Physical gold is a tangible asset that you can see and touch, which some investors find more attractive than an intangible asset.
- No counterparty risk: With physical gold, you don't have to worry about counterparty risk, which is the risk that the person or company you are dealing with will default on their obligations.
- Potential for appreciation: Physical gold has the potential to appreciate in value over time, making it a good investment for those looking for long-term gains.
Risks of Physical Gold
- High transaction costs: When you buy physical gold, you'll likely have to pay a premium over the spot price, and when you sell, you may receive less than the spot price.
- Storage and security concerns: If you own physical gold, you'll need to find a safe place to store it, which can be costly and inconvenient.
- Low liquidity: If you need to sell your physical gold quickly, you may have difficulty finding a buyer, especially if the market is in a downturn.
Benefits of Gold ETFs
- Low transaction costs: When you buy and sell gold ETFs, you pay a commission to your broker, which is typically much lower than the transaction costs associated with physical gold.
- Liquidity: Gold ETFs are highly liquid, meaning you can buy and sell shares quickly and easily.
- Diversification: With gold ETFs, you can invest in an asset that tends to perform with low correlation to other assets, which can help spread risk in a portfolio.
Risks of Gold ETFs
- No tangible asset: Unlike physical gold, gold ETFs are not a tangible asset, which may make some investors uncomfortable during volatile market conditions.
- Counterparty risk: When you invest in a gold ETF, you are exposed to counterparty risk, meaning that if the ETF's issuer defaults, you could lose some or all of your investment.
- Tracking error: Gold ETFs may not track the price of gold perfectly, meaning investors may not get the full benefit of a rise in the price of gold.
How Are Gold ETFs Taxed?
How gold ETFs are taxed will depend on their legal structure and how they track the price of gold, which is either through the purchase of futures contracts or through holding physical gold. Taxation on gold ETFs will also depend on the type of account that an investor is using to hold the fund.
Like physical gold, gold ETFs that hold physical gold are taxed as collectibles. For example, capital gains coming from a gold ETF structured as a trust are subject to the top 28% capital gains tax rate for collectibles, such as art. Gold ETFs that aren’t structured as a trust or don’t directly invest in the precious metal aren’t subject to this top rate.
A commodity ETF structured as a partnership, and that owns gold futures contracts, has a special “60/40” tax rule, which requires that investors report the ETF’s capital gains at a hybrid rate of 60% long-term and 40% short-term gains. This can apply even if the investor didn’t sell shares. Gold ETFs investing in futures contracts provide investors with a Schedule K-1 rather than a Form 1099 to report capital gains.
However, ETFs holding physical gold do not distribute their profits to investors, so they do not produce annual tax costs for investors. Therefore, capital gains taxes would only be due if the investor sells shares of the gold ETF and realizes a gain. These ETFs are often structured as grantor trusts.
If an investor holds a gold ETF in a tax-advantaged account such as an IRA, 401(k) or Roth IRA, the investor will not owe taxes on any gains until they withdraw money from the account. In a traditional IRA or 401(k), taxes are owed on money withdrawn at the investor’s ordinary income tax rate. In a Roth IRA, investors do not owe any taxes on money withdrawn that are qualified distributions.
Bottom Line
A gold ETF offers investors exposure to the price of gold without the hassle of owning physical gold. Additionally, gold ETFs are generally less expensive, more liquid and more diversified than owning physical gold or a single stock in a gold mining company. Before buying shares of a gold ETF, investors should understand their unique structures, risks and taxation.
