Low yields from bond investments across the globe have left investors seeking other sources of income, and dividend stocks have often been where such investors have turned.
The need for income-paying dividend stocks, as well as the expansion of the market for exchange-traded funds (ETFs), have made dividend ETFs increasingly popular.
With dividend ETFs, not only do shareholders have exposure to potential gains in share price, they may be able to line their pockets with additional income in the form of quarterly payouts. Plus, even if share prices aren’t roaring along, these dividends can still provide a little income boost.
Let’s dig deeper into dividend ETFs.
ETFs Basics
An ETF is a fund that allows individuals to invest in a diversified basket of investments, such as stocks, bonds, and other assets.
Most ETFs track some sort of index, such as the S&P 500, which itself tracks the performance of the 500 largest U.S. stocks. Their holdings primarily mirror the assets included in the index. That said, there may be a small percentage of the portfolio that may lie outside the fund and vary a little bit depending on fund manager choices.
As the name suggests, “exchange-traded funds” are traded in real time on exchanges, such as the New York Stock Exchange or Nasdaq. The price of the ETF fluctuates throughout the day, and these funds can be bought and sold all day.
This is an important distinction from how mutual funds work, which also allow individuals to invest in a basket of investments. Mutual fund trading is done once per day at the end of the trading day.
Another important difference is that ETFs typically have lower fees than mutual funds. Because ETFs that track an index are usually passively managed, they don’t require a lot of intervention and work from fund managers. Less time and energy from fund managers translates into lower fees that end up being passed on to investors.
Recommended: ETFs vs. Mutual Funds: What’s the Difference?
How Dividend ETFs Work
A dividend ETF works much the same as a regular ETF, though they usually track part or all of a dividend stock index. For example, a dividend ETF might track the Dow Jones U.S. Select Dividend Index , which consists of 100 dividend-paying stocks.
Dividend stocks are securities that pay a portion of company profits out to shareholders. Those dividends are usually paid on a fixed schedule. The process involves three important dates: the declaration date, the date of record, and the payment date.
The declaration date is the day the board of directors announces that it will pay a dividend. The date of record, also known as the ex-dividend date, is the day shareholders “of record” are entitled to the dividend. And finally, the payment date is the actual day that the dividend is paid out. Dividends are usually distributed to shareholders in the form of cash.
Do ETFs Pay Dividends?
Dividend ETFs collect the dividend payments from their underlying stocks and make distributions to the ETF shareholders. The process of payment from a dividend ETFs mirrors that of single dividend stocks. There is a record date, ex-dividend date, and a payment date.
That said, the ETF’s schedule may be different from the schedules followed by its underlying stocks. Dividend ETFs usually make payments according to a regular schedule, which is described in the fund’s prospectus and is publicly available.
Recommended: What are Dividends and How Do They Work?
Types of Dividends
Qualified dividends are those that can be taxed at the capital gains rate. The capital gains rate then depends on the investor’s modified adjusted gross income (MAGI). This is also known as the preferential rate.
In contrast, unqualified dividends are taxed at income tax rates, which are generally higher than capital gains tax rates.
The Internal Revenue Service (IRS) requires that investors hold shares for more than 60 days during a 121-day period. The period starts 60 days before the ex-dividend date.
Recommended: What Is the Current Capital Gains Tax Rate?
How Dividend ETFs Are Taxed
ETFs may also be more tax efficient than other similar investments. That’s because they’re passive investments with little turnover in the holdings. The process of creating and redeeming ETF shares are also not subject to capital gains taxes on any individual security within the fund.
Dividend ETFs are a little bit more complicated when it comes to taxes due to the way dividends are taxed by the IRS. There’s no escaping tax on dividends. Shareholder dividends are taxable in the year that they are received whether they are paid in cash or whether they are reinvested. The first thing to pay attention to is whether you are receiving qualified dividends.
The bottom line: Rules for dividend taxation may be complicated, but there are no special rules you have to remember that differentiate how dividends from ETFs are taxed versus those from regular dividend stocks. What matters most is whether those dividends are qualified or unqualified in the eyes of the IRS.
Types of Dividend ETFs
There are hundreds of dividend ETFs that can track all sorts of indexes. We’ve already mentioned one that tracks the Dow Jones U.S. Select Dividend Index of U.S. stocks. Others may track global indexes, while some may target specific indexes by country.
Still others will target equities of specific sizes, or styles, or sector. Some track bond indexes of varying risk. And others target real estate or currency or alternatives. The variety can be dizzying, but investors can take a look at what’s available by looking at the ETF Database directory.
The dividend options on offer leave investors with plenty to choose from. Here’s a closer look at just a few categories of dividend ETFs that investors may encounter:
Dividend Growth ETFs
A company that’s steadily growing its profits should theoretically be able to offer higher dividends in the future. That’s the reasoning behind dividend growth ETFs, which target companies that show increasing profits and sales.
Dividend Value ETFs
Value stocks, like those targeted by dividend value ETFs, are those that operate in relatively stable industries but are priced cheaply compared to the potential value of the company.
They typically have a low price-to-earnings ratio. The idea is that the company may experience a future jump in share price as investors catch on to the company’s true value. Shares inside the ETFs could provide a nice boost in price in addition to the dividends they provide.
Recommended: Value vs. Growth Stocks: What to Know
High Dividend Yield ETFs
This category of ETFs goes after stocks that produce high dividend yields. But here’s the rub: While the payout for these stocks may be big, it doesn’t necessarily mean that the stock will grow particularly fast. In other words, you may be trading swift share price growth for high dividend yields.
Also, as stock price goes down, yield goes up. It’s counterintuitive, but the way this math works out may actually be masking the fact that you’re losing money on the price of the stock. Investors could potentially combat this by looking for ETFs that invest in stocks that at least keep pace with the market long-term.
Some dividend ETFs target the so-called “Dogs of the Dow”. The Dow is an index that comprises the 30 largest U.S. industrial stocks. The “dogs” are the 10 highest-paying dividend stocks within this index, yet they also tend to be the lowest performers when it comes to price gain—hence their slightly unflattering moniker.
One example of a high dividend yield ETF is the Vanguard high Dividend Yield ETF (VYM), which has about $36 billion in assets.
Reinvesting Dividends
Reinvesting dividends is the process of using the income collected from a holding and immediately buying more shares of the stock or ETF that pays out the dividend. The practice is commonly known as dividend-reinvestment plans (DRIP).
The Takeaway
ETFs provide a built-in way to add diversification through the basket of stocks they invest in. Even so, you may still want to consider how the ETF will fit into your overall plan.
When choosing a dividend ETF, you might consider your overall portfolio allocation and diversification. Your portfolio may be built based on three factors: your goals, your time horizon, and your risk tolerance. Adding an investment without considering these factors could throw off your careful plans.
You can also find out quite a bit of information about a fund from its prospectus, which is filed with the Securities and Exchange Commission (SEC) and is available to every member of the public. The prospectus can give you information such as past returns, as well as what kinds of fees you can expect to pay when you invest in the fund. You should also be able to learn more about the fund’s investment strategy.
Once you’ve decided on a fund and you want to purchase shares, you could do so inside an Active Investing account with SoFi. You can buy and sell your own stocks, all with no commission and no account minimums. You’ll also have access to financial advisors who can help you figure out the options to suit your needs. To learn more about how to build your investment portfolio, visit SoFi Invest®.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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