If you’ve ever opened up your mutual fund statement, you’ve probably, at one point or another, noticed that your fund made a dividend distribution.
Recognizing the rules around why and how mutual funds distribute dividends can be important, because any form of misunderstanding could lead to increased tax burdens and other unintended consequences.
Why Do Mutual Funds Pay Dividends?
If a security held by the fund makes a dividend or interest distribution, the fund must pass that distribution on to its shareholders. Mutual funds pass on these dividends because, quite simply, they’re required to in order to avoid taxation. Income-focused funds that invest in bonds and other short-term securities often make these distributions on a monthly basis, whereas stock funds may make them less frequently or not at all. Dividend distributions are usually taxable to shareholders as ordinary income in the year that they are made.
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How Are Dividend Payments Determined?
Dividend payments are based on income accrued by the fund’s holdings within a given period of time. Dividends and interest received from one of the fund’s holdings are held by the fund prior to being eventually distributed to shareholders. Dividend distributions usually vary because the fund will buy and sell securities on an ongoing basis, and because companies can raise or lower their dividend payments at any time. The level of payments made is determined by the types of securities that a fund holds. A junk bond fund, for example, may pay a significant monthly dividend thanks to the high yields of the bonds it holds. A large-cap stock fund that holds mostly mature dividend-paying stocks often produces a lower but steady payment. A small-cap growth fund may pay no dividend at all, since the companies it holds often reinvest their profits back into the business instead of paying them out as dividends.
Many income-focused funds that invest primarily in bonds and money-market securities accrue their dividends on a daily basis despite being only paid out on a monthly or less frequent basis. The Vanguard Short-Term Bond Index Fund (VBISX) is an example of a fund that accrues dividends daily. These funds do this in order to ensure that shareholders only earn dividends for the days that they are shareholders of the fund. For example, a shareholder that buys a mutual fund on May 30 and sells on June 3 will only receive credit for five total days of dividends. In this example, if the fund distributes dividends monthly, the shareholder will only receive two days worth of dividends (May 30 and 31) for the May month-end distribution.
Use our Dividend Screener to find high-quality dividend paying stocks. You can also use “Stock Category” filter like this to choose non-equity (i.e. MLPs, REITs, ETFs, ETNs, Funds and Notes) securities that pay a dividend. Furthermore, you can download this customised list into a spreadsheet using the “Export Screener Results in a CSV” feature that can be found at the bottom of a screener table.
How Do Dividends Affect a Fund’s NAV?
A mutual fund’s net asset value is the total value of all securities held by the fund. All dividends and interest payments earned by the fund initially become part of the fund’s total net asset value and would, therefore, increase the fund’s daily NAV. A dividend distribution made by the fund would be removing assets from a fund’s NAV. When a dividend distribution is made, the fund’s daily NAV would be reduced by the amount of the distribution.
For example, an equity-income mutual fund accrues stock dividends and makes a distribution of accrued dividends at the end of the quarter. If the fund had a NAV of $30 per share and the fund were to make a $1 per share dividend distribution, the fund’s NAV would drop to $29. However, it is important to note that because the distribution remains the property of the shareholder, he or she has lost no overall value on his investment despite the drop in the share price.
If you’re looking for an ETF equivalent to a mutual fund, check out our Mutual Fund to ETF tool.
Should You Have Dividends Reinvested or Paid Out?
The decision on whether to reinvest dividend distributions or have them paid out is entirely the preference of the shareholder. Many longer-term investors who have no immediate need for the cash choose to have their dividends reinvested in additional shares of the mutual fund. This dividend reinvestment generally allows account balances to grow faster over time compared to if the dividends were paid out. Retirees, for example, may choose to have their dividends paid out, as they may use the regular income to fund their lifestyle.
Choosing one or the other does not change the tax implications of the distribution. In non-retirement accounts, dividend distributions are taxable as ordinary income either way. Most retirement plan accounts, such as IRAs and 401(k)s, require shareholders to reinvest any distributions made by the fund.
To learn more about how mutual funds compare to ETFs as far as fees and expenses are concerned, click here.
The Bottom Line
Dividends typically make up a significant chunk of a mutual fund’s total return, so it’s important to understand how best to manage these distributions. Mutual funds can be a great way to produce regular income, but there are a number of factors that go into how much a fund can be expected to pay out. Whether in a taxable or retirement account, investing in a fund that distributes dividends regularly is one of the best ways to generate solid long-term returns.