An income distribution from a mutual fund to its shareholders can take two forms:

  1. A shareholder can elect to be paid directly, which puts the money in his or her pocket
  2. The shareholder can elect to buy more shares of the fund, which means that he or she is reinvesting the amount of the dividend in more shares.

Whichever scenario mutual fund shareholders choose, they either benefit from $100 paid to them in cash or $100 reinvested in additional shares of the ABC Fund. If you are living off investment income, you will choose one of the dividend payout alternatives. If you are building a retirement nest egg, you will choose to plow that dividend back into more shares of the fund and enjoy the long-term benefits of compounding your investment.(For related reading, see Compound Your Way To Retirement.)

For example, let's say the ABC Fund makes a quarterly income distribution of $100 as a dividend to shareholder Mary Smith. If the fund company has a money market fund, Mary could put the $100 there, which keeps it liquid and at her immediate disposal. The $100 could be sent to her by check or deposited to her bank account. In all of these instances, Mary gets to use the dividend amount any way she pleases. As an alternative, she can elect to reinvest the $100 dividend payment in more shares of the ABC Fund. Generally, this is done through automatic dividend reinvestment instructions established by Mary and automatically executed by the fund company for her account. The dollar amount of her investment in the fund will increase by $100.

By law, mutual funds must pay out income and realized capital gains to the funds' shareholders. These distributions come from a fund's assets, which why a fund's net asset value - and therefore its price - drops accordingly.

To learn more about how price and NAV are related, read Why is it that when investors realize returns on a mutual fund, its price tends to fall?

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