Everyone likes to get a little something extra. In the case of 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 dividends. Even when share prices aren’t roaring along, these dividends may still provide a little income boost.
Exchange-Traded Fund Basics
To get started, let’s take a look at some exchange-traded fund (ETF) 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.
Some ETFs are actively managed, meaning that fund managers may not track an index but rather build a portfolio that helps them meet stated investment objectives. Assets in actively managed funds may be bought and sold throughout the day without regard to underlying assets within an index.
As the name suggests, ETFs 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 when an investor buys or sells an ETF, the transaction is immediate.
This is an important distinction from mutual funds, 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 factor of ETF investing that sets ETFs apart from mutual funds is that they typically have lower fees. Because ETFs that track an index are usually passively managed, they don’t require a lot of intervention from fund managers.
Less time and energy from fund managers translates into lower fees that end up being passed on to investors. In other words, ETFs tend to be relatively cheap when it comes to fees compared with other investment options. What’s more, ETFs may be more tax efficient than other similar investments, which might make them a good choice for inclusion in taxable investment accounts.
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, which may be reinvested in the underlying fund. In some cases, this may actually be a boon to investors since reinvested dividends may not cost the investor a trade fee.
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.
How Dividend ETFs Are Taxed
To understand how ETFs are taxed, first take a look at their underlying assets—they are often taxed the same. For example, if an ETF holds a basket of stocks, that ETF is likely taxed just like the stocks.
In this case, if you hold the ETF for less than a year, when you sell you are subject to short-term capital gains taxes. If you hold the ETF for longer than a year, you are subject to long-term capital gains taxes.
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, which must meet certain criteria:
Qualified dividends must be paid out by American companies or qualified foreign companies. This may be a no brainer, but the dividends must actually be recognized by the IRS and cannot be listed as unqualified.
There are a few things that may seem like dividends but actually aren’t, such as dividends from co-ops or annual distributions from credit unions.
There are also holding period restrictions that must be met. Dividends can only be qualified if you hold the underlying asset for 60 days before the dividend is issued.
Here’s why all of this matters: Unqualified dividend are subject to regular income tax, while qualified dividends are given a preferential rate.
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.
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.
High-Yield Bond ETFs
The goal of these ETFs is high yields from fixed income investments. High yields almost always come with a tradeoff of some sort. In this case, the tradeoff is risk. Riskier bonds with low credit ratings, such as junk bonds, have higher yields than less-risky bonds, such as government bonds.
If you’re okay with taking on this risk, you may be rewarded with higher yields. But be aware that bonds in this category are at a higher risk of default, and demand for these bonds may fall if interest rates rise.
Choosing a Dividend ETF
As with any investment you’re considering adding to your portfolio, you might want to do as much research as possible before you buy. You often can’t tell much about what a fund invests in based on the name of the fund.
You should consider digging deeper by looking up the funds you’re interested in as well as the index that they report tracking.
Doing so might give you a better idea of what types of investments the fund holds and can help ensure that you don’t take on anything that is too risky or makes you uncomfortable.
You can also find out quite a bit of information about a fund from it’s prospectus, which is filed with the Securities and Exchange Commission (SEC) and is available to every member of the public whether or not they own shares in the fund.
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.
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.
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.
For example, if your portfolio already contains an appropriate exposure to stocks outside the U.S., you might want to carefully consider your options before adding a dividend ETF that focuses on foreign stocks.
When You’re Ready to Invest
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 fees 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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