Generating Income with ETFs: What You Need to Know (2024)

Etfs

January 9, 2023 Beginner

How do ETFs work? Learn how income-producing ETFs can potentially help contribute to retirement income and your financial goals.

Generating Income with ETFs: What You Need to Know (1)

Some exchange-traded funds, or ETFs, can provide a potential income stream that may offer more diversification than investing in just one stock. Whether you’re reorganizing your portfolio for your golden years or just starting to research income-oriented funds, you might want to consider this investment type.

To get started, let's look at some basic information.

What's an ETF?

An ETF is a basket of securities that trades on an exchange like a single stock. For example, an ETF may hold an assortment of stocks, bonds, loans, currencies, precious metals, futures contracts, or other types of investments. ETFs attempt to spread out risk among multiple investments, but allow investors to purchase exposure to the basket through a single security.

Like mutual funds, ETFs come in a variety of forms. Some ETFs aim to produce income through investments in fixed income securities or stocks that have historically paid dividends. Others target a specific sector, like financials or energy. Others invest in commodities or hold precious metals.

Historically, most ETFs have attempted to replicate the performance of published indexes. However, there are also many actively managed ETFs which do not track published indexes.

Unlike a mutual fund, which is priced and settled once a day at its net asset value (NAV), an ETF is listed on an exchange and can be bought or sold throughout the trading day. Just like a stock, prices fluctuate during each session. This may allow investors to get both the potential advantages of a diversified investment as well as the flexibility of intraday buying and selling.

How ETFs can potentially help generate income

Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds.

Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock. If an investor owns shares of an ETF, they may receive distributions, known as dividends, on a regular basis (monthly or at some other interval, depending on the ETF).

How to choose high-income producing ETFs

Here are some types of ETFs an income-seeking investor might want to consider:

  • Dividend-paying equity ETFsoffer potential capital gains from increases in the prices of the stocks your ETF owns, plus dividends paid out by those stocks.
  • Bond fund ETFsmay provide more reliable interest income from investments held in government bonds, agency bonds, municipal bonds, corporate bonds, and more.
  • Real Estate Investment Trusts (REITs) ETFs make money from the underlying capital gains on property sales and service (rental) income generated by the apartments, hotels, office buildings, or other real estate owned by the REITs in which the ETF has invested.

Investors might consider complementing their portfolio with ETFs or creating an income-generating portfolio constructed only of ETFs. Either way, it’s important to consider taking a diversified approach so you’re not overly exposed to one asset class.

Some cost and tax considerations for ETF income

ETFs can be a low-cost way to pursue portfolio diversification because they can avoid the higher transaction costs often associated with individual stock picking or the often higher expense ratios of actively managed mutual funds.

But, to note, some actively managed ETFs and smart beta ETFs have higher expense ratios than passive ETFs and some ETFs have higher expense ratios than mutual funds, so it's important for investors to research their choices and read each fund’s prospectus before investing.

The tax implications of ETFs can be complicated and vary depending on the asset class and structure.

If an investor sells an ETF for more than they purchased it, they may owe capital gains tax on the profits they received. In general, the taxation of most ETF investments depends on how long the investor has held the fund. If the investor owns the ETF shares for less than a year, the gains are taxed at the same rate as ordinary income. If the fund is held for longer than a year, the profits will be taxed at capital gains rates. However, the legal structure of the particular ETF can complicate the tax picture. Some ETFs are taxed differently due to their structures as trusts or limited partnerships.

Any interest or dividend income an investor may receive while invested in an ETF, however, is taxable in the year they receive the payment, regardless of whether they’re still invested in the ETF. Some dividends from equity ETFs are "qualified" and are taxed at similar rates to capital gains. Bond market investors will also owe taxes on any interest paid, and the interest is typically taxed like ordinary income, except for municipal bonds, which are typically free from federal taxes.

Fees vary across funds everywhere. Read the prospectus carefully, particularly if there are two or more ETFs tracking the same or similar indexes. You may find one ETF charges more in fees for the same investment versus another ETF with lower fees. Comparison shop for cost savings. And make sure the underlying securities of the ETF match what you’re looking for.

No investment is a sure thing, but a well-constructed portfolio that might include ETFs can potentially help you create a steady stream of income for day-to-day expenses, travel and other discretionary items, or maybe to enhance your savings.

We can help you get started with ETFs.

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Investments Etfs

Investors should consider carefully information contained in the prospectus, or if available, the summary prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares of ETFs are bought and sold at market price, which may be higher or lower than the net asset value (NAV). Some specialized exchange-traded funds can be subject to additional market risks.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Dividend-focused funds may underperform funds that do not limit their investment to dividend-paying stocks. Stocks held by the fund may reduce or stop paying dividends, affecting the fund’s ability to generate income.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

Risks of investing in REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and credit worthiness of the issuer. Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk, and liquidity risk.

This material is intended for informational purposes only and should not be considered a personalized recommendation or investment advice. Investors should review investment strategies for their own particular situations before making any investment decisions.

This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner, or Investment Manager.

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Generating Income with ETFs: What You Need to Know (2024)

FAQs

How do you use ETFs for generating income? ›

Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.

How do you actually make money from ETFs? ›

How do ETFs make money for investors?
  1. Interest distributions if the ETF invests in bonds.
  2. Dividend. + read full definition distributions if the ETF invests in stocks that pay dividends.
  3. Capital gains distributions if the ETF sells an investment. + read full definition for more than it paid.
Sep 25, 2023

Are ETFs a good way to build wealth? ›

For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio. In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends.

Do ETFs generate taxable income? ›

Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.

How do you get passive income from an ETF? ›

Investing in dividend ETFs. Dividend ETFs are another option for investors to seek consistent income. A dividend stock aims to pay a portion of the company's earnings to its shareholders on a regular basis, typically quarterly. Dividends are usually distributed as cash or additional shares of stock.

Are ETFs good for passive income? ›

A premium passive income producer

Its primary goal is to deliver monthly income and equity market exposure with less volatility than the broader stock market. The ETF has certainly lived up to its name over the past year, delivering premium income compared to other yield-focused asset classes.

How long should you hold an EFT? ›

Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.

How does ETF work for dummies? ›

ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn't occur until after the markets close.

Is it smart to just invest in ETFs? ›

If you're looking for an easy solution to investing, ETFs can be an excellent choice. ETFs typically offer a diversified allocation to whatever you're investing in (stocks, bonds or both). You want to beat most investors, even the pros, with little effort.

What is the downside to an ETF? ›

At any given time, the spread on an ETF may be high, and the market price of shares may not correspond to the intraday value of the underlying securities. Those are not good times to transact business. Make sure you know what an ETF's current intraday value is as well as the market price of the shares before you buy.

What is the single biggest ETF risk? ›

The single biggest risk in ETFs is market risk.

What is the most profitable ETF to invest in? ›

7 Best ETFs to Buy Now
ETFAssets Under ManagementExpense Ratio
Vanguard Information Technology ETF (VGT)$70 billion0.10%
VanEck Semiconductor ETF (SMH)$16.3 billion0.35%
Invesco S&P MidCap Momentum ETF (XMMO)$1.6 billion0.34%
SPDR S&P Homebuilders ETF (XHB)$1.8 billion0.35%
3 more rows
Apr 3, 2024

How do I avoid taxes on my ETF? ›

If you hold these investments in a tax-deferred account, you generally won't be taxed until you make a withdrawal, and the withdrawal will be taxed at your current ordinary income tax rate. If you invest in stocks and bonds via ETFs, you probably won't be in for many surprises.

Why do I have capital gains if I didn't sell anything? ›

That's because mutual funds must distribute any dividends and net realized capital gains earned on their holdings over the prior 12 months. For investors with taxable accounts, these distributions are taxable income, even if the money is reinvested in additional fund shares and they have not sold any shares.

Do you pay taxes on ETF losses? ›

Tax loss rules

Losses in ETFs usually are treated just like losses on stock sales, which generate capital losses. The losses are either short term or long term, depending on how long you owned the shares. If more than one year, the loss is long term.

Does ETF count as income? ›

Most currency ETFs are in the form of grantor trusts. This means the profit from the trust creates a tax liability for the ETF shareholder, which is taxed as ordinary income. 9 They do not receive any special treatment, such as long-term capital gains, even if you hold the ETF for several years.

What ETF makes the most money? ›

100 Highest 5 Year ETF Returns
SymbolName5-Year Return
PSIInvesco Semiconductors ETF21.78%
XLKTechnology Select Sector SPDR Fund21.28%
SOXLDirexion Daily Semiconductor Bull 3x Shares21.06%
IYWiShares U.S. Technology ETF20.86%
93 more rows

How do ETFs work for dummies? ›

ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn't occur until after the markets close.

How much of my salary should I invest in ETFs? ›

Investing 15% of your income is generally a good rule of thumb to meet your long-term goals. Even if you can't afford to invest that much today, you can still start investing with what you can afford. Your investment amount may fluctuate as your cash flow changes, but staying consistent can pay off in the long run.

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