Everybody Loves Income: How Dividend ETFs Work
Dividend ETFs, which focus on stocks that provide regular cash payouts, are a simple way for investors to access well-diversified sources of income.
ETFs can hold specific stocks with well-established high dividend payments, like Coca-Cola (KO) or Apple (AAPL); or they can hold equity asset classes that are well known for their stable dividend streams, such as REITs.
How Do ETFs Pay Dividends to Investors?
Like a dividend-paying stock, a dividend ETF will set an ex-dividend date, a record date, and a payout date. The timing of these dates is up to the ETF (but usually happens at least once a year, and often quarterly), and has little connection to the stocks in its portfolio.
The ETF’s dividends can be either paid out in cash or re-invested. Either way they’re taxable, although reinvestments will circumvent trade commissions.
How Are ETF Dividends Taxed?
Speaking of taxes, ETFs have a lot of control over how much their shareholders are taxed. Due to the in-kind transactions that power the creation/redemption mechanism, ETF investors are typically not on the hook for capital gains tax.
However, ETFs cannot defer income taxes on the dividends that they pay out. These dividends are taxable in the same way that dividends from a mutual fund would be.
Who Are Dividend ETFs for?
While dividend ETFs are useful for all investors, they are particularly attractive to investors who are risk-averse and/or in need of income.
Older investors, particularly retirees who rely on income from their investments, can benefit greatly from the regular cash flow that dividend ETFs provide.
Furthermore, dividend-paying stocks tend to perform better than their non-dividend-paying counterparts during turbulent times, and they tend to have less volatility. In fact, healthy dividends are a classic indicator of company strength, meaning they imply that the stock as a whole is usually a better long-term investment.
What’s the Difference Between High Yield and Dividend Growth?
There are two main types of dividend strategies that dividend ETFs can employ: high yield and dividend growth.
A high-yield strategy focuses on investments that generate large dividend payouts. While this strategy isn’t as balanced for long-term growth, it can provide investors with an influx of income from the jump at time of purchase.
Meanwhile, a dividend growth strategy seeks out companies that are steadily increasing their dividends over time. High-yield companies won’t necessarily be able to grow their dividends at the same rate as companies focused on dividend growth, but older investors might not have the time horizon to be able to wait for the amount of time it takes a dividend growth ETF to catch up or surpass a high-yield investment.
Dividend ETFs are a key component in healthy portfolios, and even younger investors with long time horizons can reap benefits from them. Plus, they save investors the time, energy, and research needed to seek out individual dividend stocks that can beat the index, mitigate their risks, and provide steady income.
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