Are ETFs that pay dividends less desirable?
Hello, Thanks for your time in this forum. I have a question about ETFs. The Investopedia article found here states to avoid dividend bearing ETFs because it increases tax exposure. How exactly? Secondly, I haven't seen many ETFs grow share price. Long term plays on them wouldn't result in much of a return if they didn't provide a dividend. For example, I have some shares of iShare's PFF. It bears some dividends and it seems that it is built to maintain a moderate per share price and produce dividends intentionally. So is it still a bad play or a tax risk at least?
Hello. There are many moving parts to this question.
To begin, I respectfully disagree with the advice/opinion given in the link you provided. Common stock dividends paid by qualified U.S. companies actually enjoy tax-favored status (i.e., lower federal tax rate) relative to ordinary income tax rates. To the extent that an ETF may invest in shares of companies that pay qualified dividends, the dividends that are passed along to shareholders through the ETF may be a nice, lightly taxed income stream. For more on this, see the following link - How ETF Dividends are Taxed (Investopedia).
The fact that you own PFF may also explain why you have not seen much in the way of capital appreciation from your ETF, as preferred stocks tend not to trade much above their $25 par value, lest they are called by the issuing company. Preferred stocks can, however, lose significant value in a rising interest rate environment or in the event of company specific financial difficulties.
There are, in fact, plenty of ETFs that invest in stocks, including those that invest in dividend paying stocks that have rewarded shareholders with price appreciation over the last several years. At the end of the day, as with its open-end mutual fund siblings, the change in value in a ETF must reflect the value of the underlying portfolio of securities in which it invests. Since ETFs are typically less inclined to make capital gains distributions, the rise in share price over time is more evident in ETFs.
It is also worth mentioning that consideration of dividend/interest paying ETFs may also depend upon whether the ETFs are held in a taxable account or a tax-sheltered retirement account.
Always a good idea to consult with one’s CPA on such matters.
If you want to reinvest your dividends, a mutual fund may be a better choice. If you want to use the dividend cash for other purposes, then there is nothing wrong with an ETF. Either way, dividends are taxed based on their nature. Qualified dividends at 0%, 15%, or 20% depending on your income, and non-qualified dividends as ordinary income.
Dividends are always taxable when distributed or reinvested if the investment is in a non-retirement account. If the account is a retirement account, the dividends can be reinvested without immediate taxation or no taxation if they are in a Roth IRA. IShare PFF is a good fund if you are seeking income. Since it is preferred stock, it acts more like a bond. There is tax risk if it is not in a retirement account.