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Investments that pay out dividends — or payments to investors when the company posts a profit — are surefire ways to boost your income. It’s essentially “free money.”
ETFs give you the best of both worlds. They can provide you with dividends and protect your money with diversification. Now you’re really winning.
ETFs stand for exchange-traded funds, and they are one of the best and easiest ways for beginner investors to get started in the stock market. But if you’re investing in dividend ETFs and getting free money, experts say you shouldn’t really pocket it.
Here’s which ETFs pay dividends, what you should do with the money, and what to look for to make sure you’re buying dividend ETFs.
What Are ETFs?
ETFs, many of which are index funds, are great investments for beginners because of their diversification. You can get hundreds of stocks in one ETF. When you diversify your investment portfolio, it means your money is spread out among hundreds of stocks, instead of just a few. In other words, if a single stock tanks, you’re not out of all your money.
Most ETFs pay out dividends. One of the telltale signs of whether an ETF pays a dividend can sometimes be in the fund name. If you see “dividend,” the ETF is seeking to pay them out regularly.
When you’re researching an ETF by typing in the fund name or ticker symbol, two things you can look for are distribution amounts or dividend yields, adds Kacie Swartz, certified financial planner at Stone Wealth Management. Usually, this information is on the first page or prominently displayed in the fund information.
But keep in mind that just because you are essentially getting “free money,” you don’t really want to spend it. According to experts, reinvesting the dividends helps you take advantage of compound interest and is a better move for most investors.
All of NextAdvisor’s 5 best index funds with low expense ratios pay dividends:
- Schwab S&P 500 Index Fund (SWPPX). Dividend: $0.86. Frequency: Annually
- Vanguard S&P 500 ETF (VOO). Dividend: $0.82. Frequency: Quarterly
- Fidelity ZERO Large Cap Index (FNILX). Dividend: $0.16. Frequency: Annually
- Fidelity 500 Index Fund (FXAIX): Dividend: $0.58. Frequency: Quarterly
- Vanguard Value Index Fund Investor Shares (VVIAX). Dividend: $0.35. Frequency: Quarterly
And there are also funds that have “dividend” in the name, such as:
The amount you’ll receive in dividends will depend on the number and weight of the companies contained within each fund.
Pro Tip
Most low-cost, broad market index funds issue dividend payments. When you receive a dividend, experts recommend reinvesting it back into your portfolio instead of pocketing the money. This helps you take advantage of compound interest and time in the market.
Types of Dividends ETFs Issue
Most low-cost, broad market index funds issue dividend payments. When you receive a dividend, experts recommend reinvesting it back into your portfolio instead of pocketing the money. This helps you take advantage of compound interest and time in the market.
“There are two different types,” explains Jordan Hanson, certified financial planner and wealth advisor at HCR Wealth Advisors, and those are qualified and nonqualified dividends.
Qualified dividends are the more favorable of the two because they’re taxed at long-term capital gains tax rates compared to nonqualified dividends, which are taxed as ordinary income.
What makes dividends qualified is twofold, Hanson explains. The first requirement is that the ETF itself must own the underlying stock that paid the dividend for more than 60 days. And second, you must own the ETF for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, the last day investors can purchase an ETF and expect to receive a dividend payment the next time they’re issued.
You won’t run into this issue with the vast majority of ETFs, which have held their stocks for a long time, particularly if the ETF only contains company stocks, and you own the ETF before the ex-dividend date.
If you or the dividend don’t meet this criteria, they’re taxed at your ordinary income tax rate.
Most ETFs issue dividends quarterly as a matter of tradition, but there’s no set schedule which ETFs must follow. Some ETFs pay out monthly, semi-annually, or annually.
As part of your fund research, you’ll be able to check how often you’ll receive your dividend. Note that if you purchase a fund after the ex-dividend date, you won’t receive the next payout and will have to wait until the following dividend payment date.
There’s no real advantage to receiving dividends quarterly instead of annually, unless you’re closer to retirement age and want to use them for living expenses. If you’re investing long-term, it’s something to note but not remarkably important.
It’s reassuring to know that ETFs are considered one of the most tax-efficient investments choices, notes Swartz.
Your brokerage will provide a year-end tax statement that breaks down your dividend payouts of $10 or more on Form 1099-DIV, Dividends and Distributions (although some brokerages report all dividends). This form will include if they’re qualified or nonqualified.
Qualified dividends are taxed at lower capital gains rates of 0%, 15%, or 20% depending on your filing status and tax bracket, while nonqualified dividends are taxed at your ordinary income tax rate.
If you sell an ETF after holding it for over a year, you’ll pay the long-term capital gains rate, and if you sell before a year is up, any gains will be taxed as regular income.
In general, it’s a good idea to hold onto your investments long-term. If you do, you’ll pay the lower capital gains rate while also taking advantage of the power of compound interest to supercharge your earnings, especially if you choose to reinvest your dividends.
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