IS IT BETTER

to pay no taxes or pay taxes but earn more income? That's the question facing investors of exchange-traded funds when it comes to dividends.

Many people are drawn to the tax-efficiency of exchange-traded funds over mutual funds. As the sales pitch usually goes, while mutual funds present a taxable event for fund investors by distributing capital gains on a yearly basis, ETF investors only pay taxes when they sell their shares.

In truth, though, that's an oversimplification of how taxes work with ETFs. You do have a tax bill to pay in some cases, notably on the dividend income you earn. But that shouldn't be a deal killer: While taxes must be paid on ETF dividends, the upside is if this earned money is considered qualified dividend income, or QDI, it can add more than two percentage points to an ETF portfolio's return. That means you pay more in taxes, but it could be worth it on bottom-line returns.

"If you're really considering tax efficiency, look at the whole package, not just capital gains," says Noel Archard, principal of the Vanguard Group, the fund giant based in Valley Forge, Pa. "The low capital-gain production is just part of the story. Focus on the income side as well and that is where QDI will become important over the next couple of years."

Congress made the dividend tax more palatable in 2003. Instead of taxing dividends at the investor's regular tax rate, which could be as high as 35%, the rate on qualified dividend income fell to 15%. That applies to ETFs as well as regular stocks.

There are some caveats. Only equity investors benefit: Most of the income earned from bonds and money-market funds is interest, which doesn't meet the QDI requirements. Plus, the lower tax rates on dividends are set to expire in 2008, though Congress could renew the break.

Still, ETFs do have a lot of advantages over mutual funds in the ability to pay a higher dividend, and, therefore, boost the return. For one thing, ETFs generally carry lower expenses than traditional mutual funds. All mutual funds and ETFs are required to pay down expenses with cash earmarked for dividend and interest payments before they tap into their core assets. The higher the expenses, the less money left over for dividends.

Some ETFs have taken advantage of the tax efficiency by creating indexes of dividend-paying stocks. The downside of this approach is that, typically, the companies paying the best dividends are usually more mature companies, with less potential for stock-price gains. However, Vanguard, PowerShares and State Street Global Advisors offer ETFs comprised of companies offering high dividend income as well as significant growth potential.

It's hardest to tell how well the investing strategy works with the Vanguard Dividend Appreciation Index. While issued in April, right before the market's recent downturn began, the ETF is still only down 2% since its launch, compared with the 3% drop in the S&P 500 index. Meanwhile PowerShares' dividend ETFs are up on the year. The PowerShares High Yield Equity Dividend Achievers Portfolio is up 3% year-to-date, while PowerShares High Growth Rate Equity Dividend Achievers Portfolio rose 1.8%. PowerShares Dividend Achievers Portfolio has gained 3.8% so far this year and the PowerShares International Dividend Achievers Portfolio has climbed 7% through Wednesday's close.

The gain in the International Dividend Achievers Portfolio is most surprising, considering many foreign stocks are not eligible for QDI. Nonqualified dividends include those from foreign stocks which distribute a foreign tax credit, passive foreign investment companies, and securities from countries that don't have a favorable tax treaty with the U.S.

Indeed, even eligible stocks need to follow strict rules before their eligible dividend income actually qualifies for the 15% tax rate.

First, dividends from real estate investment trusts don't qualify. "The dividend tax cut was intended to address the double taxation of dividends," says Dodd Kittsley, State Street's director of ETF research. "Since REIT dividends are not taxed at the corporate level, the dividends that they pay shareholders are subject to tax at ordinary rates."

Another potential problem deals with the "holding period." Both the fund and the investor must hold the dividend-paying stocks for at least 61 continuous days during the 121-day period beginning 60 days before the ex-dividend date and 60 days after. The ex-dividend date is the first date that the buyer will not be entitled to receive that dividend. If the ETF holds for the appropriate time period, but the investor doesn't, then the dividends still don't qualify.

"If the investor is tax aware, he will make sure he holds it for 61 days," says Duncan W. Richardson, chief equity investment officer at Eaton Vance, an investment-management company in Boston.

It also means that folks who actively trade ETFs shouldn't expect the dividend-tax break. "In order to get the tax benefit you need the long-term view, because the short-term view chews up your interest in taxes and expenses," Richardson says.