Should you reinvest dividends in ETFs?
Why Should I Reinvest ETF Dividends? Unless you need the cash flows generated from dividends for income, reinvesting those proceeds to buy more ETF shares can compound returns over time and lead to even greater dividend income down the road.
The IRS considers any dividends you receive as taxable income, whether you reinvest them or not. When you reinvest dividends, for tax purposes you are essentially receiving the dividend and then using it to purchase more shares.
Cashing out instead will preclude you from multiplying your investment. It May Take Longer To Achieve Long-Term Financial Goals: Dividend reinvestment leads to compounded growth. This makes it easier (and faster) to achieve your long-term financial goals versus keeping cash in a savings account.
Dividend-paying ETFs can be a great tool for those looking to increase cash flow and diversify their investments. They offer a simple solution to getting exposure to a specific investing niche — in this case, stocks that pay a regular dividend.
Over time, the cash flow generated by those dividend payments can supplement your Social Security and pension income. Perhaps, it can even provide all the money you need to maintain your preretirement lifestyle. It is possible to live off dividends if you do a little planning.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
What is the downside to reinvesting dividends? Dividend reinvestment has some drawbacks. One downside is that investors have no control over the price at which they buy shares. If the stock gains significant value, they'd still buy shares at what could be a high price.
If you reinvest dividends, you can supercharge your long-term returns because of the power of compounding. Your dividends buy more shares, which increases your dividend the next time, which lets you buy even more shares, and so on.
9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.
What is the downside of dividend ETF?
Cons. No guarantee of future dividends. Stock price declines may offset yield. Dividends are taxed in the year they are distributed to shareholders.
Symbol | Name | Dividend Yield |
---|---|---|
MSFO | YieldMax MSFT Option Income Strategy ETF | 19.46% |
PYPY | YieldMax PYPL Option Income Strategy ETF | 19.36% |
TLTW | iShares 20+ Year Treasury Bond BuyWrite Strategy ETF | 18.78% |
DISO | YieldMax DIS Option Income Strategy ETF | 18.41% |
Our recommendation for the best overall dividend ETF is the Schwab U.S. Dividend ETF (SCHD), thanks to a combination of high Morningstar rating, rigorous index methodology, low expense ratio, competitive yields and strong historical performance.
If, for example, your portfolio gets to a value of $1.5 million, you could invest in a fund or multiple investments that yield an average of 3.3%. At that rate, you could generate $50,000 in annual dividends. With a lower portfolio balance of $1 million, you would need to target an average yield of 5%.
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
You'll also get some excellent income starting from day one. The Vanguard High Dividend Yield ETF pays out 3.0% annually, or more than double the 1.4% yield you would get from an S&P 500 index fund. So invest $5,000 in the ETF, for example, and you can expect $150 per year of passive income.
ETFs are most often linked to a benchmarking index, meaning that they are often not designed to outperform that index. Investors looking for this type of outperformance (which also, of course, carries added risks) should perhaps look to other opportunities.
Theoretically, for exotic ETFs, yes — but as a practical matter highly unlikely. And for broad market ETFs that track something like the S&P 500 Index the probability of going to zero is, well, about zero. Every stock in the index would have to go to zero.
Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification. But the number of ETFs is not what you should be looking at.
If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.
How long should you hold an ETF?
Holding period:
If you hold ETF shares for one year or less, then gain is short-term capital gain. If you hold ETF shares for more than one year, then gain is long-term capital gain.
If you hold these investments in a tax-deferred account, you generally won't be taxed until you make a withdrawal, and the withdrawal will be taxed at your current ordinary income tax rate. If you invest in stocks and bonds via ETFs, you probably won't be in for many surprises.
When you are 5-10 years from retirement, stop automatic dividend reinvestment. This is when you transition from an accumulation asset allocation to a de-risked asset allocation. In Summary: When in accumulation, reinvest dividends. When in transition or drawdown, don't!
Your investment goals. If your goal is long-term portfolio growth, dividend reinvestment makes sense: Reinvested dividends help grow your investment. If you aim to generate an income stream or fund an immediate financial need, you're better off taking cash dividends.
Dividends are taxable regardless of whether you take them in cash or reinvest them in the mutual fund that pays them out. You incur the tax liability in the year in which the dividends are reinvested.
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