dividends from etfs
Source: Pixabay

How Do Dividends From ETFs Work?

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An ETF (exchange-traded fund) is a basket of stocks that represents the composition of an index, such as the S&P 500. Each ETF typically focuses on a specific asset class, sector, or category. ETFs offer investors a basket of various securities, ranging from modern securities such as commodities and currencies to traditional stocks and bonds. Investors can invest in ETFs to diversify their portfolios.

ETFs tend to be cost effective, as they're generally managed passively by a fund manager and typically track one market index. The goal of ETFs is to offer investors the opportunity to invest in various assets at a low cost. ETFs are traded on an exchange similar to stocks. As a result, investors can take advantage of price fluctuations during a trading day. A key difference between mutual funds and ETFs is intraday trading. Mutual funds, not traded on an exchange, trade only once per day when the market closes. You can trade and invest in ETFs through online brokers such as Robinhood and TD Ameritrade

Do you get dividends from ETFs?

Shareholders in ETFs don’t directly own the fund's underlying assets. When you buy units of an ETF, you're buying units of a portfolio that mirrors a designated index. ETFs are required to pay out the entire amount of dividends received from the stocks held in their funds. The dividends are distributed to shareholders on a pro rata basis.

dividends from etfs
Source: Pixabay

An ETF generally distributes dividends either in the form of additional units of the ETF or in cash. The amount investors receive in dividends depends on how many units of the ETF they own. For instance, if 1,000 shares of an ETF are outstanding and a single investor owns 100, the investor would own 10 percent of the portfolio. As a result, the investor would be entitled to receive 10 percent of dividend payments. Like an individual company’s stock, an ETF specifies a record date, ex-dividend date, and payment date. These dates designate who receives the dividends and when the dividends are paid. 

Are dividends from ETFs qualified?

An ETF can pay out two types of dividends to investors: qualified and non-qualified. The tax consequences of the dividends received by the investor depend on factors such as how long the underlying stock was held by the fund.

If qualified, dividends are subject to long-term capital gain tax rates, which tend to be lower and depend on household income. Qualified dividends are paid when the underlying stock is held for more than 60 days before the ex-dividend date. If non-qualified, dividends are subject to ordinary income tax rates. Non-qualified dividends are determined by subtracting qualified dividends from the total amount of dividends.

In 2020, most companies have reduced or suspended their dividend payments to shareholders due to the coronavirus pandemic. This move has impacted the ETFs that focus on dividend-paying stocks such as AT&T, Microsoft, and Bank of America. Most industry experts believe that there's even more decline ahead.

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