An exchange-traded fund (ETF) includes a basket of securities and trades on an exchange. If the stocks owned by the fund pay dividends, the money is passed along to the investor. Most ETFs pay these dividends quarterly on a pro-rata basis, where payments are based on the number of shares the investor owns.
Key Takeaways
- ETFs pay dividends earned from the underlying stocks held in the ETF.
- An ETF that receives dividends must pay them to investors in cash or additional shares of the ETF.
- Dividends may be taxed at the long-term capital gains rate or the investor's ordinary income tax rate.
Allocating Dividends
If an ETF has 100 shares of a company outstanding, the investor who owns ten shares has the right to 10% of the dividends earned by the ETF. The financial institution managing the ETF will receive the distribution and pass it to investors, usually quarterly.
If five stocks in the ETF pay quarterly dividends of $1 each and the fund owns ten shares of each of the stocks, the fund earns $50 in dividends per quarter. The investor who owns 10% of the shares of the ETF earns a quarterly dividend payment of $5.
The first ETF introduced in 1993 was the SPDR S&P 500 ETF (SPY), which tracks theS&P 500 Index.
Types of Dividends
There are two types of dividends that an ETF can pay to investors: qualified dividends and non-qualified dividends. The tax consequences for the two are different. Most investors will pay a lower rate on capital gains than on ordinary income. As of 2023, the capital gains tax was 0%, 15%, or 20% depending on income. The earned income tax rates range up to 37%.
- Qualified dividends: The ETF designates if the dividends distributed are qualified. The dividends are then taxed at the capital gains rate based on an investor's modified adjusted gross income (MAGI) and the taxable income rate that ranges from 0% to 20% in 2023, as determined by the Internal Revenue Service (IRS). An investor only earns the ETF-qualified dividend if they own the shares for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
- Non-qualified dividends: Non-qualified dividends are the remaining ETF dividends equal to the total dividends minus any dividends treated as qualified dividends. These dividends are taxed at the investor's ordinary income tax rate and are commonly paid on stocks held by the ETF for 60 days or less.
8,800
The number of ETFs available to investors globally in 2023.
How Are ETF Dividends Paid to Investors?
ETF dividends maybe paid to investors in the form of a cash distribution or a reinvestment in additionalshares of the ETF.
How Do Individuals Invest in ETFs?
ETFs can be purchased or sold on a stock exchange in the same way as individual stocks. An ETF contains a basket of securities and is commonly structured to follow an index or industry sector, such as commodities, technology, or biotechnology.
How Do Investors Determine What Dividends Are Paid by an ETF?
Investors can research the dividend yield for the ETF, which is expressed as a percentage. The yield reveals how much a company pays out individendseach year relative to its stock price. Some ETFs focus on high-dividend investments. Two ETFs that focus on dividends include the SPDR S&P Dividend ETF (SDY), which tracks the S&P High-Yield Dividend Aristocrats Index, and the Vanguard Dividend Appreciation ETF (VIG), which invests in companies that have increased dividends for at least ten consecutive years.
The Bottom Line
Exchange-traded funds are similar to stocks in that they can be bought and sold throughout the trading day. An investor who wants to reap the benefits of dividends can choose an ETF that focuses on dividend-paying stocks. Dividends can be distributed as cash or reinvested in the ETF.
Correction—Dec. 1, 2022: This article was edited to update the definitions of both qualified and unqualified dividends that may be paid to investors in an Exchange Traded Fund (ETF).
