There are thousands of mutual funds to choose from, and most share the basic characteristics that have made them a popular investment option. Among them are liquidity, diversification, and professional management. But only some of those funds have another benefit, and that is a high dividend yield.

High-dividend-yield funds appeal to investors who place a priority on consistent income. These funds invest only in high-dividend stocks and high-coupon bonds in order to provide shareholders with regular income year after year.

This income is paid in the form of dividend distributions, which represent the investor's portion of the fund's earnings from all sources.

Many funds are designed to avoid dividend-generating assets and interest-paying bonds in order to minimize the tax liability of their shareholders. Others focus on the potential for fast growth of stock prices rather than the steady but more modest income from dividends. But these funds, too, may have some dividend distributions.

In any case, all funds are required by law to distribute their accumulated dividends at least once a year, but from there the timing and other details may vary significantly.

Understanding Dividend-Paying Funds

Dividends represent a portion of a company’s profits. Companies that are thriving financially often pass through a portion of their profits to shareholders in the form of dividends.

Each shareholder gets a set amount for each share held. For example, IBM paid a dividend of $1.62 per share on June 10, 2019. Coca-Cola paid a dividend of 40 cents a share. Boeing announced a dividend of $2.055 per share.

In a high-dividend-yield fund, this income can constitute a major chunk of its total return. Funds that are growth-oriented may earn modest dividends on only a handful of holdings.

Mutual fund investors may take dividend distributions when they are issued or may choose to reinvest the money in additional fund shares.

Mutual funds that receive any dividends from the investments in their portfolios are required by law to pass them on to their shareholders. The exact manner in which funds do this can differ.

How Interest Payments Are Counted

A mutual fund may have a portfolio that includes dividend-bearing stocks or interest-bearing bonds, or both.

Mutual funds are required to pass on all net income to shareholders in the form of dividend payments, including interest earned by debt securities such as corporate and government bonds, Treasury bills and Treasury notes.

A bond typically pays a fixed rate of interest each year, called its coupon payment. The payment is a percentage of the bond's face value.

Unlike stock dividends, bond interest is guaranteed and the amount of the payment is established upfront.

Investors researching funds need to know whether the historical returns they see on the fund fact sheet include the reinvestment of dividends—in other words, don't inflate its potential returns by assuming it includes the growth rate plus dividend distributions.

Aggregation and Timing

Most companies that pay dividends on preferred stock or common stock or both typically do so on a quarterly basis. There are companies that pay on a semi-annual basis and even a few that issue dividend checks monthly.

Mutual funds collect this income and then distribute it to shareholders on a pro-rata basis.

All funds are legally required to distribute their accumulated dividends at least once a year. Those that are geared towards current income will pay dividends on a quarterly or even monthly basis. But many others only pay out dividends on an annual or semiannual basis in order to minimize administrative costs.

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 in their portfolios also is aggregated and distributed to shareholders on a pro-rata basis. These may appear on the statements as dividend income.

About Dividend Reinvestment

Some investors, especially those who are not retirees, prefer to reinvest their dividends rather than receive a payout. Establishing a dividend reinvestment plan is easy with mutual funds. The investor simply notifies the broker or fund company to automatically reinvest the cash into additional shares.

Shareholders can also use their dividends to purchase shares of a different fund. The fund company usually permits this as long as the second fund is within its own family. Independent brokers and investment firms often do this regardless of what fund is being purchased.

Key Takeaways

  • Dividends are the investor's portion of a company’s profits. The company approves the amount based on its financial results.
  • Interest is the payment to investors for loaning a sum of money to a government or corporation in the form of a bond or other debt instrument.
  • Both stock dividends and bond interest are paid by mutual funds as dividend distributions to fund investors.

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.

Unless they come from funds within an individual retirement account (IRA) or tax-advantaged retirement plan, all dividends are now treated as ordinary income in the year that they are paid.

Mutual fund dividends are reported on Form 1099-DIV like dividends from individual stocks.

The rules for reinvestment, aggregation, and pricing are also largely the same for master limited partnerships, real estate investment trusts, target-date funds, and exchange-traded funds (ETFs) that pay dividends.