Can Bond ETF Dividends Be Reinvested Commission Free?

You can choose between two common vehicles for bond funds: mutual funds and exchange-traded funds. They both are backed by a portfolio of bonds and they both distribute periodic dividends. Although technically classified as “dividends," these distributions are taxed in the same manner as interest, at your marginal tax rate. These dividends do not qualify for any special tax breaks normally afforded to stock dividends. Mutual funds routinely allow you to reinvest dividends without commissions, but ETFs are less consistent.

Bond ETFs start life as initial public offerings (IPOs) of stock. The stock is backed by a basket of bonds that may be tied to a published bond index. Once issued, the ETF stock trades like any other, on a stock exchange. You must pay two different fees to own shares in a bond ETF. First, you pay a brokerage commission to buy the shares. For example, discount brokers might charge around $4 for the purchase of 100 shares, but commissions would vary substantially. Once you own the shares, you pay a management fee to the fund. Bond ETF management fees typically begin around 0.2 percent a year and rise from there.

The distinction between mutual funds and ETFs is important when it comes to dividend reinvestment. If reinvested, bond fund dividends might result in fractional shares. Mutual funds create new shares as needed and routinely deal with fractional shares. ETF shares trade in whole units – you cannot sell a quarter of a share on the stock market. However, many brokers are willing to represent fractional shares in your account, and you earn dividends on these just as you do on whole shares. Some brokers extend this courtesy, while others do not. Your broker may charge a commission for reinvesting ETF dividends, but many do so for free.

Many ETF managers offer dividend reinvestment plans when you buy shares from a broker who supplies the shares directly from the ETF management company instead of through a stock exchange transaction. The bond fund dividends are automatically reinvested in your brokerage account, including any fractional shares. Almost all reinvestment plans charge no commission for this service. You must pay taxes on bond fund dividends for the tax year in which they are issued, whether or not you reinvest them, unless you shield the ETF shares inside a retirement account.