Blog How Do ETF Dividends Work?

How Do ETF Dividends Work?

ETFs, or exchange-traded funds have most to do with growth investing and index-tracking; however, many ETFs offer income in the form of dividend-paying stocks. When this happens, they collect regular dividend payments and distribute them to all ETF shareholders.

At the discretion of the fund’s management, there are two different ways to distribute these dividends. Either paid out in cash to the investors or reinvested into the exchange-traded funds’ investments.

How Do the Dividends Get Allocated?

Let’s use a real-life example; let’s say there are 1000 shares from an ETF, and an investor holds 100 of those shares. At this point, they own them, ten percent of all dividends or profit retained from that ETF.

If the ETF happens to consist of five dividend-paying stock investments, that means all the quarterly dividends get put into a pool for distribution to shareholders on a per-share basis.

If the five dividend-paying stocks all paid a quarterly dividend of $2, and the ETF owns 100 shares of every dividend-paying stock, then the total amount in dividends made by the ETF would be $1000 every quarter. The investor that has 100 shares of this ETF would get $100 each quarter.

Afterward, the ETF would then distribute the $300 to the owners, and then to the investors.

ETFs will typically keep the profit from the many different underlying securities, and once every quarter, they make a payment out to the investor. This payment can be in the form of cash or reinvest into more shares of the ETF.

What Are the Different Types of Dividends?

The two types of dividends that an investor can receive from an ETF payout are non-qualified and qualified dividends. The tax repercussions of the two types differ considerably.

With qualified dividends, they qualify for a special tax rate called long or short-term capital gains. Moreover, the underlying stock must be in the investor’s possession for longer than 60 days (out of 121 days) before the ex-dividend date.

On the other hand, non-qualified dividends get taxed at the ordinary income tax rate of the investor.

Cash Dividends Examples

SPDR S&P 500 is an ETF that pays out dividends in the form of cash. The fund’s prospectus states that the SPDR S&P 500 ETF places all dividends that it receives from the underlying stock holdings into an account that bears no interest until the time comes to make a payout.

When dividends are due to be paid at the end of the fiscal quarter, the SPDR S&P 500 ETF will take the profit from the account that bears zero interest and distribute the dividends to the investors proportionally.

Some ETFs will temporarily reinvest the dividends from the underlying stocks into the holdings of the fund. That is, up until it’s time to make a cash payment for dividends.

As a result, there’s a bit of leverage within the fund. This leverage can either harm its performance during a bear market or improve its performance during a bull market.

Reinvested Dividends Examples

ETF managers have the option of reinvesting the dividends of their investors into the ETF as opposed to distributing them as cash. Therefore, the payout to the shareholders can also take place through reinvesting into the ETF’s underlying index, on behalf of the shareholders.

It all works out to be the same: In this situation, however, if an ETF shareholder receives a 5% dividend reinvestment from an ETF, the investor may then sell the shares if cash is preferred.

In many cases, these kinds of investments are very beneficial. The reason is that the investors do not get charged a trade fee to buy more shares through the dividend reinvestment.

There’s one caveat: all shareholders’ annual dividends are taxable in the year that they’re received. That is even the case if they get received through dividend reinvestment.

Taxes on ETF Dividends

ETFs are often considered a suitable alternative to mutual funds. That has mostly to do with when and how the taxable capital gains get collected in ETFs.

Remember that by owning ETFs which produce dividends, you do not defer any income tax generated by the dividends paid out by an ETF during any given tax year. All dividends paid by ETFs are taxable to the investors in the same way that dividends paid by a mutual fund are taxable.

Final Thoughts

As a potential investor, it’s important to remember that even though ETFs are typically known for broad indexes, like the Russell 2000 or the S&P 500, you can find ETFs which focus on dividend-paying stocks.

Dividends are a reliable investment as they have accounted for nearly 40% of the total returns of the entire stock market. Furthermore, consistent and reliable dividend payout history is a sure-fire sign of a profitable corporation.