Using Dividend ETFs as a Reinvestment Strategy

Investors who hold shares of an exchange-traded fund, or ETF, that invests in stocks may receive dividends just as they would by holding shares of companies that pay shareholder dividends.

ETF dividends can provide a source of income, which may be attractive for certain investors, especially those in their retirement years. If an investor chooses to reinvest their ETF dividends, they can benefit from compound interest, helping their investments grow over time.

ETFs invest in several assets at once. They often track an index. But, unlike mutual funds, shares of ETFs are bought and sold over an exchange, just like stocks. Some investors choose to invest in ETFs for diversification, which may help reduce risk.

An ETF can pay dividends if it owns dividend-paying stocks.¹ It may pay investors regularly—monthly, quarterly, or annually, for example—or dividends may be issued as a special case, such as when a company within the ETF performs well and has a larger amount of cash than usual. However, dividends are not guaranteed. Companies facing financial troubles may be forced to cut or eliminate their dividend payments.

The IRS requires a 1099-DIV form to be issued to a shareholder if an investor is paid $10 or more of dividends. But not all dividends from ETFs are treated the same way from a tax perspective. Some are qualified dividends, which means they're subject to tax at the capital gains rate, while others are nonqualified and taxed at ordinary income rates.

The difference between qualified and nonqualified dividends typically is typically determined by the amount of time an ETF holds the underlying stock, and the amount of time a dividend ETF shareholder holds a share of the fund. Understanding the tax implications of ETFs and the ins and outs of dividends can be complex, learn more about ETFs and taxes and always consult with your tax professional for any questions about the taxation of ETFs.

Each investor can set a unique course for using dividend ETFs to help pursue their financial goals. The strategy for each investor will depend on their risk tolerance, time horizon, and income needs.

Like stocks, dividend ETFs can vary significantly. Some are suitable for investors who may want lower risk. Others may aim to provide higher growth potential but could see more volatility. For example, some ETFs hold established large-cap stocks, while others may hold smaller small-cap stocks.

If you choose to invest in a dividend ETF, whether for income or reinvesting, check with your financial institution or brokerage firm to learn about any possible associated fees or costs.

When you reinvest dividends, you use the cash to buy additional shares in the ETF, increasing your stake. This way, the payments that would normally go into your pocket are instead used to buy shares, or fractional shares, of the ETF.

Reinvesting dividends might change the overall return of your portfolio as you accumulate capital over the long term. The additional shares may yield more dividends, thus creating a compounding effect. But remember, companies may reduce or cut their dividends at any time, so it's important for investors to do their research to find companies with sound financial metrics to help mitigate this risk. Additionally, a stock paying a dividend can still decline in price, which would reduce the total return.