Have your cake and income, too.
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Do you like the growth potential of stocks, but get scared by high-flying companies that sometimes fall to Earth? Or maybe youâre looking for income-generating investments, but want better returns than bonds offer? Dividend exchange-traded funds (ETFs) may be worth considering.
Dividend ETFs hold a basket of dividend stocksâshares of companies that prioritize periodic payments to shareholdersâin a single tradable security. Dividends are paid to shareholders from a portion of the companiesâ profits. Many dividend ETFs follow an index, such as the Dow Jones U.S. Dividend 100 Index tracked by the Schwab U.S. Dividend Equity ETF (SCHD), although more actively managed ETFs are coming to market.
These ETFs are popular with investors who want steady income and a little growth. They appeal to those looking to transition their portfolios as they move toward retirement. The best dividend-paying ETFs suit your own investment goals and time horizon. Keep in mind that dividend payments arenât guaranteed, but dividend ETFs help spread out the risk.
Key Points
- Dividend ETFs are a low-cost way to invest in many dividend-paying stocks in one security, offering liquidity and flexibility.
- Dividends can be paid out on a schedule or reinvested back into the fund.
- Dividend ETFs are divided into two main categories: growth and high-yield dividends.
Why invest in dividend ETFs?
The allure of passively watching income payments hit your investment account is enticing. Owning dividend ETFs can be a winning strategy for workers nearing retirement looking for long-term growth, a steady income stream, and capital appreciation.
Slow and steady
Bonds have a reputation for being boring investments, but theyâre another good source of dividend income. And just as buying an ETF or mutual fund allows you to invest in many different stocks in one fell swoop, a bond fund lets you hold several dividend-paying debt securities in the same instrument. Learn more about bond funds.
Unlike owning individual dividend-paying stocks, dividend ETFs (and their counterpart, dividend mutual funds) hold numerous stocks in a single trading vehicle that investors can easily buy and sell. Dividend ETFs and mutual funds share much in common, but they have a few key differences.
Dividend ETFs
Dividend mutual funds
- Usually actively managed
- Slightly higher fees than ETFs
- Trade only once a day
- May have a minimum investment cost
- Setting up an automatic dollar cost averaging plan is easy
Dividend ETFs may hold companies from any sector, but generally, they include staid businesses that grow slowly or have consistent earnings. Examples include consumer staples (such as food producers), utilities, communication services, some health care, and traditional energy stocks. These sectors usually have slower growth, so they offer dividend payments to entice investors.Â
Investors new to dividend ETFs might zero in on a juicy yield, but before you buy, itâs key to know why that yield is so high. Dividend ETFs are divided into two main categories: growth and high-yield dividends.
- Dividend growers: These ETFs focus on companies with a history of raising their dividends over time and may have a lower current yield. These stocks balance ongoing growth and payments on top of capital appreciation, and they emphasize sustainable payments over high income. Certain dividend-growing companies are known as dividend aristocrats; these are S&P 500âlisted companies that have increased the dividend paid to shareholders annually for 25 consecutive years. One ETF that holds such shares is ProShares S&P 500 Dividend Aristocrats ETF (NOBL).
- High-yield dividend: These ETFs prioritize higher dividend yields; the focus is on immediate income, rather than a history of growing the dividend over the long term. Note that higher-than-average dividend payments may not be sustainableâsome financially challenged companies offer high dividends. Schwab U.S. Dividend Equity ETF (SCHD) is a high-yield dividend ETF.
When choosing among dividend ETFs, read the fundâs strategy and its objective, including whether it follows an index or is actively managed. That information is found on the fundâs website and in more detail in the prospectus.
Have you started saving toward retirement? If so, great! But how do you decide what to invest in?
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How dividend ETFs pay income
Income generated by dividend ETFs is distributed in two ways:
- Cash payments. Retirees seeking to live off the income generated by dividend ETFs can get distributions paid directly to their brokerage accounts.
- Reinvesting. Many dividend ETFs offer a dividend reinvestment plan, known as a DRIP, which allows holders to automatically funnel the dividends into more ETF shares. The benefit of selecting a DRIP is compounding returns, which can increase how many shares you own over time.
ETFs in general are known for their tax efficiency, but that isnât necessarily the case for dividend ETFs. Income generated by dividend ETFs may be subject to taxation, depending on where they are heldâin a taxable or tax-sheltered accountâand the tax rate varies depending on whether the ETF holdings are considered qualified or nonqualified dividends. You may get a tax bill even if you decide to reinvest the income from nonqualified dividends held in a taxable account.
Sorting out ETF dividends
Dividends paid on ETF funds come in two types: qualified and nonqualified. Qualified dividends qualify to be taxed at the more favorable long-term capital gains rate. Nonqualified dividends are taxed at ordinary rates. To receive qualified dividends, you must have held shares in the ETF for more than 60 days during a specific period, and the ETF must have owned shares in the dividend-paying stock at the same time. Active traders, because they trade securities frequently, likely wonât meet the standard. But donât worry too much about figuring out whether your dividends are qualified or nonqualified. The payer is required to identify each type of dividend and report it to you on Form 1099-DIV.
Although dividend ETFs offer a steady income stream, remember that dividend payments arenât guaranteed. Companies may cut or eliminate dividends for several reasons, such as financial challenges, business strategy changes, or recessions. Many companies cut dividend payments during the financial crisis of 2007â08 and in response to the market slide caused by the COVID-19 pandemic in 2020.
When a company cuts its dividends, it may signal internal issues. But owning a dividend ETF may help shield you from individual company stress because these funds own many stocks, spreading out the risk.
Dividend ETFs are an easy way to invest in numerous dividend-paying companies with a single vehicle. Theyâre popular with those nearing retirement who want to reduce the risk associated with holding single stocks, but stay invested and earn some income. Reducing risk doesnât eliminate it, since all investing involves some risk. There are many dividend ETFs, so read the fundsâ prospectuses and compare their holdings to help determine which funds suit your investing style. If youâre looking for a steady income stream while possibly benefiting from market growth and capital appreciation, dividend ETFs may be a good fit for your portfolio.
Specific companies and funds are mentioned in this article for educational purposes only and not as an endorsement.
This article was most recently revised and updated by Debbie CarlsonThis article was most recently revised and updated by David Schepp
