Looking to target income in a portfolio, but you'd also like to participate in any growth potential and aim for diversification? You might consider dividend ETFs. Here's why.
Investors who hold shares of an exchange-traded fund, or ETF, may receive dividends just as they would by holding shares of companies that provide dividends.
ETF dividends can provide a source of income, which can be attractive for investors in their retirement years. ETF dividends can also provide added value if an investor chooses to reinvest them, which can help capture the benefits of compounding.
ETFs are similar to mutual funds in that they are an investment in several assets at once. They often track an index. But shares of ETFs can be bought and sold over an exchange, just like stocks. Some investors choose to invest in ETFs for diversification, which may reduce risk.
An ETF can pay dividends if it owns dividend-paying stocks. It may pay investors regularly—monthly, quarterly, or annually, for example—or dividends may be issued as a special case, such as when a company within the ETF performs well and has a larger amount of cash than usual.
When you reinvest your dividends, you use the cash to buy additional shares in the ETF, increasing your stake. You can do this manually or by using a dividend reinvestment plan (DRIP) that does it automatically. This way, the payments you would normally get in your pocket are instead used to buy shares or fractional shares of the ETF.
Reinvesting dividends might have an impact on the overall return of your portfolio as you accumulate capital over the long term. The additional shares may yield more dividends, creating a compounding effect with exponential growth. Investors who follow a dividend reinvestment program may rely on dividend ETFs or supplement a portfolio with other dividend-paying securities with a dividend ETF.
To enroll in a dividend reinvestment program through TD Ameritrade, call 800-699-3900 or visit a TD Ameritrade branch. There are no service fees or commissions to participate in a DRIP through TD Ameritrade. For more on DRIPs, watch the video at the bottom of the page.
If you receive dividends of more than $10 in a year, the ETF must report the amount to the IRS. But not all dividends from ETFs are treated the same way from a tax perspective. Some are qualified dividends, which means they are subject to tax at the capital gains rate, and others are nonqualified and are taxed at ordinary rates.
The difference between qualified and nonqualified is typically the amount of time an ETF holds an underlying stock or the amount of time a dividend ETF shareholder holds a share of the fund.
Qualified dividends: Paid on stocks held by the ETF for more than 60 days in the 121-day period that starts 60 days before the ex-dividend date (the day before the company declares a dividend).
Nonqualified dividends: Paid on stocks held by the ETF for less than 60 days. Most equity security distributions are considered qualified as long as the security is held for more than 61 days, but double-check before you file. Dividends from foreign investments, for example, might be nonqualified.
Most likely, you’ll receive a 1099-DIV from your broker or other investment provider that shows the breakdown between qualified and non-qualified dividends. And remember, even automatically reinvested dividends may be taxable.
If you’re receiving significant dividends, you might need to pay taxes on them quarterly. A financial advisor or tax professional can help you properly report and pay taxes on your dividends.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
Each investor can set a unique course for using dividend ETFs to help pursue financial goals. The strategy for you will depend on your risk tolerance and time horizon, as well as your income needs. I
Like stocks, dividend ETFs can vary significantly. Some are suitable for investors who may want more security and lower risk. Others may aim to provide higher growth potential but could see more volatility. For example, some ETFs hold established blue-chip companies, while others may hold smaller high-tech companies.
Need help whittling it down? The TD Ameritrade screener tool allows clients to select among dividend criteria such as distribution yield and 12-month dividend totals. Log in to your account at tdameritrade.com and go to Research & Ideas > Screeners > ETFs > Dividends.
If you choose to invest in a dividend ETF, whether for income or reinvesting, check with your financial institution or brokerage firm to learn about any possible associated fees or costs.