Generating Income with ETFs: What You Need to Know

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.

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.

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).

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

• Dividend-paying equity ETFs offer potential capital gains from increases in the prices of the stocks your ETF owns, plus dividends paid out by those stocks.
• Bond fund ETFs may 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.

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.