Exchange-traded funds (ETFs) buy shares of a number of stocks on behalf of their investors, and when those stocks pay dividends, the money is passed along to the investor.
The dividends are typically paid either in cash or in additional shares of the ETF.
- ETFs pay out, on a pro-rata basis, the full amount of a dividend that comes from the underlying stocks held in the ETF.
- An ETF that receives dividends must pay them out to investors in the fund, either in cash or in additional shares of the ETF.
- An ETF may pay out qualified dividends, which are taxed at the long-term capital gains rate, and non-qualified dividends, which are taxed at the investor’s ordinary income tax rate.
What Are Qualified Dividends?
How Dividends Are Allocated
If there were only 100 shares of an ETF outstanding, the investor who owns 10 shares has the right to 10% of all of the dividends earned by the ETF.
The company managing the ETF will receive the dividends from the companies whose stocks are held in the ETF. The money goes into a pool and is then distributed to shareholders, usually quarterly.
In this example, say five of the stocks held in the ETF pay quarterly dividends of $1 each. The ETF owns 10 shares of each of these dividend-paying stocks, so it will earn $50 in dividends per quarter. The investor who owns 10% of the shares of the ETF would earn a quarterly dividend payment of $5.
The best-performing ETFs in mid-2022 were heavily invested in commodities, including natural gas and industrial metals. Supply-chain disruptions forced prices higher.
Two Types of Dividends an ETF Can Pay Out
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:
- Qualified dividends qualify to be reported to the Internal Revenue Service (IRS) as long-term capital gains, assuming that the underlying stock has been held for longer than 60 days prior to the ex-dividend date.
- Non-qualified dividends are taxed at the investor’s ordinary income tax rate. The total amount of non-qualified dividends held by an ETF is equal to the total dividend amount minus the total amount of dividends treated as qualified dividends.
Whether the dividends from an ETF are qualified or unqualified depends on how long the fund held the stock that paid the dividend. If the stock has been owned by the fund for less than a year, the dividends are unqualified.
Are ETFs Required to Pay out Dividends?
ETF issuers are required to pay their shareholders the dividends they collect from securities held in their funds.
However, how they choose to distribute the funds is up to the individual issuer. The proceeds from these dividends may be paid to investors in the form of a cash distribution or a reinvestment in additional shares of the ETF.
Are ETF Dividends Qualified?
Dividends paid by an ETF may be qualified or unqualified. That is, they may or may not qualify to be reported as long-term capital gains rather than regular income, thus usually allowing the investor to pay a lower tax rate on the money.
However, most dividends are taxed as ordinary income. They are “unqualified” for treatment as capital gains.
Most ETFs that pay dividends pay them quarterly, although a few pay monthly dividends.
Do ETFs Pay Dividends and Capital Gains?
ETFs are required to pay their investors any dividends they receive for shares that are held in the fund. They may pay in cash or in additional shares of the ETF.
So, ETFs pay dividends, if any of the stocks held in the fund pay dividends. That is, they collect any shareholder dividends that are paid by the companies that issued the stocks that are held in the fund, and then pay them to investors in the ETF, usually quarterly. The payment may be in cash or in additional shares of the ETF.
If you sell your shares of an ETF, you may realize a profit. The profit, or capital gain, will be taxable in the year in which you sell it.
If you sell it less than a year after you bought it, any profit will count as ordinary income for that year. If you own it for at least a year before selling it, it will be taxed at the long-term capital gains rate, which is lower for most taxpayers.
Which ETFs Pay the Most Dividends?
ETFs now come in every variety, from funds that track the S&P 500 Index to funds that invest in gold-mining stocks.
There are funds that focus on dividend-paying stocks. For example, the SPDR S&P Dividend ETF (SDY) tracks the S&P High-Yield Dividend Aristocrats Index. The Vanguard Dividend Appreciation ETF (VIG) invests in companies that have increased their dividends for at least 10 consecutive years.
Some ETFs invest in bonds and are designed to provide a regular stream of interest income to their investors. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Blackstone Senior Loan ETF (SRLN) are examples.
The Bottom Line
Exchange-traded funds are similar to stocks in that they can be bought and sold throughout the trading day. Also, the investor may harvest a capital gain when selling shares of the ETF.
Unlike some stocks, ETFs do not directly pay dividends based on their earnings. They are, however, a conduit for dividends paid by the companies they invest in.
An investor who wants to reap the benefits of dividends can choose an ETF that focuses on dividend-paying stocks. Whether they are paid in cash or reinvested, they’re a bonus on the investment.