Exchange-traded funds (ETFs) pay out the full dividend that comes with the stocks held within the funds. To do this, most ETFs pay out dividends quarterly by holding all of the dividends paid by underlying stocks during the quarter and then paying them to shareholders on a pro-rata basis. They are typically paid either in cash or in the form of additional shares of the ETF.

Key Takeaways

  • ETFs pay out, on a pro-rata basis, the full amount of a dividend that comes from the underlying stocks held in the ETF.
  • An ETF must pay out the dividends to investors and can make them either by distributing cash or by offering a reinvestment in additional shares of the ETF.
  • An ETF pays out qualified dividends, which are taxed at the long-term capital gains rate, and non-qualified dividends, which are taxed at the investor's ordinary income tax rate.

How Dividends Are Allocated

If there are 100 shares of an ETF outstanding, and an investor owns 10 shares of that ETF, he would own the right to 10% of the total dividends earned by the ETF. If the ETF were made up of five dividend-paying underlying stocks, the total amount of those quarterly dividends would be placed in a pool and distributed to shareholders of that ETF on a per-share basis.

If the five dividend-paying stocks each paid a quarterly dividend of $1, and the ETF owned 10 shares of each dividend-paying stock, the total dividends earned by the ETF would be $50 per quarter. The ETF would distribute that $50 to the owners of the ETF. The investor who owned 10 shares of the ETF would earn a quarterly dividend payment of $5 since he owns 10% of the ETF and has a right to 10% of the total dividends earned.

Most ETFs hang on to the dividends from the various underlying securities and then make a payment to the investor once a quarter, either in the form of cash or more shares of the ETF.

Two Types of Dividends an ETF Can Pay Out

There are two types of dividends that an ETF can pay out to investors: qualified dividends and non-qualified. The tax consequences for the two types of dividends differ significantly.

  • Qualified dividends qualify for long-term capital gains, and the underlying stock must be held for longer than 60 days prior to the ex-dividend date.
  • Non-qualified dividends are taxed at the investor's ordinary income tax rate. The total amount of non-qualified dividends held by an ETF is equal to the total dividend amount minus the total amount of dividends treated as qualified dividends.

Are ETFs Required to Pay out Dividends?

ETF issuers are required to pay out dividends collected from securities held in their funds. However, how they choose to distribute the funds is up to the individual issuer. The proceeds from these dividends may be paid to investors in the form of either a cash distribution or a reinvestment in additional shares (fractional) of the ETF.