ETFs have always been viewed as good long-term investments. But they can also be a great option for investors looking to start earning dividends now. Especially new investors.
Wait. What is an ETF?
An exchange-traded fund (ETF) is a type of investment traded on an exchange, just like a stock. And you can buy into one any time during the trading day at whatever price it happens to be at the time. That's different from mutual funds, which are priced at the end of each trading day, no matter what time you initiate a buy.
Unlike stocks, one ETF can hold a collection of assets, just like a mutual fund. So an investor might own an ETF that holds hundreds of different stocks. Read: instant diversification. And if your ETF contains dividend-earning stocks, it could earn you some extra cash.
Tell me more about stock ETFs.
There are ETFs for every kind of investment, including bonds, commodities, currencies, and of course, stocks. Drilling down more, ETFs can even invest in stocks in a specific industry, like tech, energy, or consumer staples. And because they're a basket of investments, ETFs are usually more cost-effective vs. buying each holding within the ETF individually.
Plus, they don’t usually have a minimum investment requirement like mutual funds. So you can start investing in ETFs with just a little cash. Which is great for anyone just starting out.
Okay. How do ETFs pay dividends?
If an ETF holds dividend-paying investments, it'll pay dividends, too. Either in cash disbursements or as reinvestments in additional ETF shares. The dividends from each of the stocks in your ETF would be collected in a pool, then disbursed to shareholders.
When do ETFs pay dividends?
Most ETF dividends are paid on a quarterly basis, but that’s not a required timeframe. The ETF issuer decides when dividends are paid to shareholders. That doesn’t mean you’ll have to guess when or if you’ll get dividends. You can find the dividend dates in every ETF’s prospectus. (Hint: the document all stocks, bonds, and mutual funds use to list investment details for the public.)
To confirm if you’ll receive dividends from your ETF, take a look at the ex-dividend date in the prospectus. This is the last date to invest in order to be eligible for the next dividend disbursement. If your purchase date is the same or after the ex-dividend date, you’ll have to wait for the next round of disbursements.
What do I need to know about taxes on dividends and ETFs?
Dividends are separated into two categories, with the main difference being tax rates:
Qualified dividends are taxed at the capital gains rate, which is usually lower than ordinary income tax rates. Depending on your filing status and income, you can expect a rate from 0% to 20%.
The catch: To collect qualified dividends, the ETF must have held the dividend-paying stocks for more than 60 days during the 121-day period that starts before the ex-dividend date. Aaaand you must have held shares of the ETF for more than 60 days before the dividend is issued. If the timing is off, your dividends will be taxed as ordinary income.
Non-qualified dividends are always taxed at your normal income tax rate. To calculate the amount of your non-qualified dividends, subtract your qualified ETF dividends from your total dividend amount.
FYI: If you’re considered a high earner, you might also notice a 3.8% Medicare tax deduction from your dividends. To make sure you’re fully prepared, read over our list of tax forms to know.
Sounds good. So how can I invest in ETFs?
Before you dive in, here are a few investment terms to get familiar with. Next, you’ll need to open a brokerage account. Once your account is up and running, it’s time to compare ETFs to find one (or more) that you want to invest in.
Just a heads up, there are tons of ETFs to choose from, and the comparison process can be a bit overwhelming. Luckily, most brokerage accounts have built-in tools to help you narrow down the options based on factors like where you live and which industry you’re most interested in.
Once you’ve found the right ETF for you, head over to the trading section of your brokerage account, make your first investment, and wait for the dividends to start rolling in.
If you’re new to investing, ETFs are a good way to get started. Because they're budget-friendly and offer easy diversification. Oh, and if your ETF contains dividend-earning stocks, they can start paying off asap.
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