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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?

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February 2016

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). 

With respect to your ishares PFF, this ETF invests in preferredstocks. The dividends paid by preferred stocks are not qualified U.S. common stock dividends, and, thus, are taxed as ordinary income. 

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.

 

February 2016
February 2016