Reinvesting the dividends that you earn from your investments is an excellent way to grow your portfolio without dipping into your wallet. While mutual funds have made dividend reinvestment easy, reinvesting your dividends earned from exchange-traded funds (ETFs) can be slightly more complicated. Dividend reinvestment can be done manually, by purchasing additional shares with the cash received from dividend payments, or automatically, if the ETF allows.
Automatic dividend reinvestment plans (DRIPs) directly from the fund sponsor are not yet available on all ETFs, although most brokerages will allow you to set up a DRIP for any ETF that pays dividends. This can be a smart idea, since there is often a longer settlement time required by ETFs and their market-based trading can make manual dividend reinvestment inefficient.
- Dividend reinvesting can be done via dividend reinvestment plans (DRIPs) or manually.
- Most mutual funds offer DRIPs, but dividend reinvesting for some ETFs still must be done manually.
- Brokerages handle automatic dividend reinvestments differently.
- A disadvantage to automatic dividend refinements for ETFs is that investors lose the ability to time the market.
- Manual dividend reinvestment is less convenient but provides more control.
Dividend Reinvestment Plans (DRIPs)
An automatic DRIP is simply a program-offered fund or brokerage firm that allows investors to have their dividends automatically used to purchase additional shares of the issuing security. This practice has been widely used in stock and mutual fund investments, but it is relatively new to ETFs.
Though DRIPs offer greater convenience and a handy way to grow your investments effortlessly, they can present some issues for ETF shareholders because of the variability in different programs. For example, some brokerage firms allow automatic dividend reinvestment but only allow the purchase of full shares. Any amount left over is deposited as cash into the investor’s brokerage account, which may be easily forgotten. Other firms pool dividends and only reinvest dividends monthly or quarterly.
Some reinvest dividends at market opening on the payable date, while others wait until the cash is actually deposited, which is typically later in the day. Because ETFs trade like stocks and their market prices can fluctuate throughout the day, a reinvestment executed at 7 a.m. may buy a different number of shares than a trade executed at 10 a.m. This is one of the drawbacks of automatic ETF dividend reinvestment; the investor loses control of the trade and cannot “time” the market to their advantage.
Dividend Reinvestment Plan (DRIP) Definition
If your brokerage firm does not provide a DRIP option, or if the ETFs in which you are invested do not allow for automatic reinvestment, you can still reinvest dividends manually. Basically, manual reinvestment means taking the cash earned from a dividend payment and executing an additional trade to buy more shares of the ETF. Depending on where you hold your investment account, you may incur a commission charge for these trades, just like you would with any other trades. However, some brokerage firms allow for commission-free dividend reinvestments.
Manual dividend reinvestment, while less convenient than a DRIP, provides the investor with greater control. Rather than simply paying the market price for new shares on the payment date, you can elect to wait if you feel that the share price may drop. It also offers the option of holding your dividends in cash if you feel that the ETF is underperforming and you want to invest elsewhere.
If you elect to manually reinvest your ETF dividends, be aware of the effect of settlement delays on the buying power of your dividends. Because ETFs, unlike mutual funds, rely on brokerages to keep track of their shareholders, dividend payments typically take longer to settle. Rather than the one-day settlement period of most mutual funds, ETF payments can take two days or more to settle. If your ETF is doing well, then the additional wait time can mean that you end up paying more per share.
The Bottom Line
Reinvesting your ETF dividends is one of the easiest ways to grow your portfolio, but the structure and trading practices of ETFs means that reinvesting may not be as simple as reinvesting mutual fund dividends. Consult your brokerage firm to see which of your ETFs is eligible for a DRIP and how the brokerage handles those trades.
If you must manually reinvest, keep track of settlement periods to ensure that you do not time your reinvestment poorly. Setting a market order for the moment when your dividend is deposited may not get you the best price per share, so use manual reinvestment to your advantage by actively managing your trades.
ETF Dividend Reinvestment FAQs
Do ETFs Pay Dividends?
If the shares or other holdings in an ETF’s portfolio pay dividends, then those also are payable to shareholders of the ETF. A few ETFs will pay dividends out as soon as they are received from each stock held in the fund, but the majority collect those dividends and distribute them on a quarterly basis.
Why Should One 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.
Are ETF Dividend Reinvestments Taxed?
Yes. The Internal Revenue Service (IRS) treats dividends that are reinvested the same as if they were received as cash, for tax purposes. As such, they must be reported on your tax returns.
Why Are DRIPs Preferred to Manual Reinvestment with ETFs?
Aside from being automatic (set-it-and-forget-it), a DRIP helps to eliminate problems with timing the reinvestment of ETF dividends. Unlike shares of stock that have a transfer agent and custodian tracking all shareholders of record for dividend purposes, ETFs rely on investors’ brokerages to track this. Additionally, there can be delays in when ETF dividends are distributed and when they actually hit an investor’s account, making manual timing more difficult.