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 mutual fund’s total return, and mutual funds that received these dividends from the investments in their portfolios are required by law to pass them on to their shareholders. However, the exact manner in which funds do this can differ (for more, see: Introduction to Dividends.)

Some mutual funds are managed with the goal of generating significant dividend income, paying out current income to investors with moderate risk tolerance. Others, primarily growth-oriented, simply pay moderate dividends as a result of a handful of holdings. 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.

Why Do Funds Pay Dividends?

A mutual fund may that pays dividends has a portfolio that includes dividend-bearing stocks or interest-bearing bonds, or both. A bond typically pays a fixed rate of interest each year, called its coupon payment, which is equal to a predetermined percentage of the bond's face value. Mutual funds are required to pass on all net income to shareholders in order to avoid taxation, so interest generated by debt securities such as bonds, bills and notes is distributed to shareholders via dividend payments.

Unlike bond interest, stock dividends are not guaranteed. However, many companies choose to pay annual cash dividends to reward long-term shareholders and encourage new investors. A mutual fund that invests in dividend stocks, therefore, passes along those earnings to its shareholders each year. Both interest and dividend income is included in a mutual fund's dividend distributions.

Some mutual funds are managed with the goal of generating significant dividend income, paying out current income to investors with moderate risk tolerance. Others, primarily growth-oriented, simply pay moderate dividends as a result of a handful of investments. 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.

Aggregation and Timing

Most companies that pay dividends -- both on preferred stocks and common stocks -- 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 each month.

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.

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 a monthly basis. But many others will 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 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

Establishing a dividend reinvestment plan is easy with mutual funds; the investor simply notifies either the broker or fund company to automatically reinvest the cash into additional shares. 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 purchase shares of a different fund in many cases; the fund company is usually willing to do this as long as the second fund in within 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.

Unless they come from funds within an individual retirement account (IRA) or tax-advantaged retirement plan, all dividends are now reported as ordinary income in the year that they are paid; the capital gains treatment that was formerly accorded to qualified dividends was repealed by Congress a few years ago. Mutual fund dividends are 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, target-date funds and exchange-traded funds (ETFs) that pay dividends. (For more, see: Dividend Tax Rates: What Investors Need to Know.)

The Bottom Line

For some investors, the possibility of consistent income is one of the primary appeals of mutual funds. High-dividend-yield funds are especially popular because they offer all the basic benefits of mutual funds, including liquidity, diversification and professional management, with the added perk of being designed specifically to maximize annual income. By investing only in high-dividend stocks and high-coupon bonds, these funds provide shareholders with regular income year after year. Conversely, some funds are designed to avoid dividend-generating assets to minimize the tax liability of shareholders.

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