Dividends represent a portion of a company’s profits, and companies that are larger and more financially established will often pass through a portion of their profits in the form of dividend income. This income can constitute a major portion of a stock or stock mutual fund’s total return, and mutual funds that received these dividends from the holdings in their portfolios are required by law to pass them on to their shareholders by law. However, the exact manner in which funds do this can differ in some cases depending upon various factors. (For more, see: Introduction to Dividends.)

Aggregation and Timing

Most companies that pay dividends do so on either a semiannual or quarterly basis. Most preferred stocks pay quarterly dividends, while common stocks tend to pay only twice a year. Investors who rely on dividend income are often therefore required to amass a fairly substantial portfolio of dividend-paying offerings in order to generate the amount of income that they desire. However, mutual funds can invest in a much larger portfolio of stocks that pay dividends, and this income is then collected and distributed to shareholders on a pro rata basis. Many of these companies will pay their dividends in different months, so that there is some dividend income to pass through every month. But many stock funds will still only pay out dividends on an annual or semiannual basis in order to minimize administrative costs. Some dividend funds are primarily growth-oriented, while others focus more on paying out current income to investors with moderate risk tolerance. In either case, investors who do research on dividend funds need to know whether the dividends are being reinvested in the historical returns that they see on the fund fact sheet. (For more, see: How ETF Dividends are Taxed.)

Although mutual funds are only legally required to pass along their income to shareholders once per year, most of the ones that are geared towards paying current income will pay dividends on either a quarterly or monthly basis. Some funds may in fact withhold some dividends in certain months and then pay them out in a later month in order to achieve a more level distribution of income. Interest that is earned from fixed-income securities inside their portfolios is likewise aggregated and distributed to shareholders on a pro rata basis and may actually be included in what is coded as dividend income in some cases. (For more, see: Which is Better: A Growth Mutual Fund or a Dividend Reinvestment Option?)

Dividend Reinvestment

Investors who own individual shares of stock can use the cash from their dividends to buy more shares if they prefer. They can either set up a dividend reinvestment program directly through the issuing company or else through their broker. The former method allows for purchase of fractional shares while the latter can usually only buy whole shares, with any remainder being swept into cash or paid to the investor. Dividend reinvestment is easy with mutual funds; the investor simply notifies either the broker or fund company to reinvest the shares and it is done automatically. And fund reinvestment plans allow fractional shares to be purchased either through the broker or the fund company. Shareholders can also use their dividends to automatically purchase shares of a different fund in many cases; the fund company is usually willing to do this as long as the shareholder is purchasing another fund in its own family. Independent brokers and investment firms are often willing to do it regardless of what fund is being purchased. (For more, see: The Perks of Dividend Reinvestment Plans.)

Tax Reporting and Share Pricing

Funds that pay dividends will reduce their share prices by the amount of the dividend being paid on the ex-dividend date in the same manner as individual stocks. For example, a fund with a share price of $10.42 that pays a dividend of $0.10 per share will trade at $10.32 on the ex-dividend date. Any shareholder who owned shares on the record date will be paid this dividend. All dividends are now reported as ordinary income in the year that it is paid; the capital gains treatment that was formerly accorded to qualified dividends has been repealed by Congress. Mutual fund dividends are likewise reported on Form 1099-DIV in the same manner as dividends from individual stocks. The rules for reinvestment, aggregation and pricing are also largely the same for master limited partnerships, real estate investment trusts and exchange-traded funds (ETFs) that pay dividends. (For more, see: Traders Look to Dividend Funds (VIG).)

The Bottom Line

The process in which mutual fund dividends are calculated, distributed and reported is fairly straightforward in most cases. Dividends that are paid outside of an individual retirement account (IRA) or tax-advantaged retirement plan must be reported as ordinary income by investors. Although funds are required to pay out their accumulated dividends at least once a year, most funds will pay them at least semiannually. For more information on mutual funds that pay dividends and how they work, visit Morningstar’s website at www.morningstar.com or consult your financial advisor. (For more, see: Dividend Tax Rates: What Investors Need to Know.)

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