Often when we think of stock market growth, we think of the increase in stock prices. But dividends represent an additional source of growth, and can be great for building supplemental income. How often do index funds pay out dividends?
As a general rule, index funds pay out dividends on a quarterly basis. There are also index funds that pay on a monthly or annual basis. Dividends can be paid as cash or as additional shares of the index fund ETF. Dividends can supplement the price growth of the index fund to increase your returns.
But there is a lot more to consider with index funds than the dividend payout and frequency. Read on to find out what to look for with index funds.
How Often Do Index Funds Pay Out?
Index funds represent an exchange traded fund (ETF) that tracks a given index (e.g. S&P 500). When you purchase an ETF, you’re essentially purchasing a portion of a fund that owns a number of stocks.
When the stocks the fund owns pay out a dividend, that gets passed on to the investors of the fund. Your individual dividen will be based on how many shares of the fund you own. So if there are 1000 outstanding shares of the fund, and you own 200, you have the rights to 20% of the dividends earned by the fund.
Most companies that pay dividends will declare the dividend after their quarterly earnings report. As such, they will issue a dividend on a quarterly (every 3 month) basis. There are some companies that will pay a dividend annually, and a rare few that will pay a dividend monthly.
Similar to the stocks that it owns, most index funds pay a dividend once a quarter, though you may find some that pay either annually or monthly. Typically this is paid in the form of cash that will be automatically deposited in your investment account, though it could also be in the form of additional shares.
What is a Dividend?
Dividends are a distribution of profit to shareholders. Organizations decide that the highest shareholder return on their profit is to pay a portion directly to them, rather than reinvest in the business.
This it typically done by larger, well-established companies. Companies in a start-up or growth phase will typically re-invest the profits to induce more growth. Larger companies however, reach a point where distributing the money to their shareholders will provide the shareholders with more value than re-investing in the business.
As mentioned above, dividends are typically declared on a quarterly basis following the companies financial reporting. Once a dividend is declared, the company has a legal responsibility to pay it. As long as you own the stock before the Ex-Dividend date and hold through the record date, you will receive the declared dividend.
When you own an index fund, not all the companies in the fund will issue dividends, which is why the index fund distribution yield (dividend percentage) is typically lower than stocks.
Are Dividends Taxed?
Dividends are taxed, though typically at a lower rate than employment income. This is because the issuing company has already paid taxes on the profits.
There are two types of dividends, and in Canada, the tax rate on them differs:
- Eligible Dividends – These are issued by large Canadian businesses that pay higher corporate tax rates. As such, the taxes for the individuals receiving the dividends are lower.
- Non-Eligible Dividends – These are issues by smaller private Canadian corporations, which have advantageous corporate tax rates. As such, the individual pays slightly more tax on these dividends.
Typically, dividends earned in an investment account will classify as eligible dividends.
The taxes on dividends can be avoided by investing in a registered account. By holding your investments in a registered account like a TFSA or RRSP, the dividends are not taxed. That said, with RRSPs, the tax is only deferred, so you will pay tax on the money when you withdraw for retirement.
Does the Dividend Frequency Matter?
Dividend frequency does not matter if you hold the index fund/stock for a long time. The yield (dividend percentage) will be the same regardles of the dividend frequency. That said, if you’re interested in regular cashflow, a more frequent dividend would be beneficial.
For example, if you are in your 20s or 30s and are investing for retirement, you will likely reinvest any dividends you receive. As such, there’s no impact to you whether the dividend pays out quarterly or annually. However, if you’re retired and you plan to use your dividend income to support your lifestyle, a more frequent dividend payout may be beneficial to keep regular cashflow.
Ultimately it’s important to assess your goals and needs for the dividends.
Should I Pick the Index Fund With The Highest Dividend?
Dividends are not the only consideration for index fund growth. When selecting index funds, the growth consists of the dividend yield, and the price growth. It’s possible to choose funds that focus on dividends, but the cumulative growth (dividend and price) is what should be maximized.
Depending on your circumstances and needs, you may desire dividends over price growth, and vice-versa.
If you are targetting a true index fund (one that aims to mimic the index), you won’t have much variability in the dividend yield. For example, most S&P 500 index funds will be around 1-1.5% dividend yield annually.
However, with other ETFs, you can target ones with high-dividends. As mentioned above, this may be of interest if you are looking to use the dividend income to supplement your living expenses. These ETFs will provide cashflow, but the price growth may be lower. The expense ratio may also be higher as there is some active management involved.
But if overall portfolio growth is your only concern, both the dividend yield and the price growth should be considered. The price growth increases the value of the index fund shares you own, and the dividend allows you to purchase more shares. When you’re investing with a long-term outlook, maximizing overall growth is in your best interest.
Dividend yield should not be your only consideration for selecting an index fund. You also need to consider price growth, and management expenses.
Can I Reinvest my Dividends?
Dividends can be re-invested to purchase more shares of the security. Typically, the dividend will be deposited as cash in your investment account. Once the cash has built up larger than the price of the ETF or stock, it can be used to purchase additional shares.
Most brokerages also have a Dividend Re-Investing Plan (DRIP), where the brokerage will automatically use the dividends you receive to purchase additional stock. This removes the need for you to go in and place an order. This can be a great option if you intend to invest in the security long-term.
Re-investing dividends is a great way to bolster your account growth.