Most investment firms that offer mutual funds offer at least one fund that is managed with the goal of creating regular dividend income, so finding a fund that pays high dividends is not all that difficult. Funds that invest primarily in energy, utilities or blue-chip stocks are popular choices because of their larger-than-average dividend payments. However, there are a number of factors to consider when shopping for a dividend fund. Before you jump into fund investing, first understand how and why a fund pays high dividends and what you might be trading for that income down the road. Also, consider how a dividend fund may align with your personal investment goals. Having a firm understanding of what a dividend fund can provide, what risks it may entail and how it factors into your own individual investment strategy helps ensure you select a mutual fund that meets your specific needs.

When Does a Mutual Fund Pay Dividends?

For a mutual fund to pay dividends, it must hold assets that generate regular income. This generally means a fund must hold dividend-bearing stocks or interest-bearing bonds. The frequency with which a fund makes dividend distributions depends on the managing firm. However, mutual funds are required to pass along all their net profits to shareholders at least once each year to avoid paying taxes on those earnings. Therefore, shareholders in a dividend fund are guaranteed to receive at least one dividend distribution each year unless all the stocks in the portfolio suspend dividends and all the bond issuers default simultaneously, which is highly unlikely.

Different Types of Dividend Funds

Any of the four primary types of mutual funds, such as stock, bond, balanced and money market, can be a high-dividend fund depending on the specific assets in the portfolio.

Dividend-oriented stock funds have portfolios that consist primarily of stocks that are proven over time to pay consistent dividends. A company pays dividends to its shareholders when it turns a profit in a given fiscal year, does not need that money to fund future growth and wants to demonstrate gratitude to stockholders for their investment and support. However, dividends on ordinary shares of stock are not guaranteed each year. If the business does not do well, or needs those funds for other expenses, the board of directors can elect to suspend ordinary dividends for any amount of time. Stock funds that pay high dividends each year, therefore, require attentive management to ensure the stocks in the portfolio pay consistently enough to provide the regular dividend income demanded by the fund's shareholders.

Bond funds are somewhat simpler because they almost always pay dividends. This is because all bonds, except zero-coupon bonds, pay a set amount of interest each year. This interest payment, expressed as a percentage of the bond's face value, is called the bond's coupon rate. Because the coupon rate and the face value of the bond are set at issuance, the amount of interest a fund receives each year from a bond in its portfolio is guaranteed and unchanging.

Balanced funds include both stock and bond investments, so they may make dividend distributions comprised of both types of income.

Money market mutual funds are similar to bond funds because they invest in debt securities. Though money market funds only invest in very short-term, highly rated securities, such as bond funds, they still pay dividends as a result of the interest income generated by their assets.

Tax Implications of Dividend Funds

While the idea of receiving consistent income from your mutual fund investment is undoubtedly enticing, consider the impact that income has on your taxes each year. All investment income you receive must be included in your taxable income. This is the chief disadvantage of high-dividend funds, since the bigger the dividend payment, the higher the tax bill.

Though there is no way to protect your investment income from taxation indefinitely, you may be able to pay a lower rate on dividend distributions depending on the source of the income.

Dividends on stocks in your fund's portfolio are taxed as ordinary income or as capital gains. Most dividend income falls into the former category and is taxed at your regular income tax rate, which is the highest rate applicable to your income. However, if your fund has held the stock for a certain amount of time and meets the IRS requirements, the dividend may be considered qualified and only subject to the capital gains tax rate. Depending on your income tax bracket, the difference between your ordinary tax rate and the corresponding capital gains tax rate can be as much as 20%. The turnover rate of a dividend fund, therefore, has important tax implications.

Dividends paid as a result of interest-bearing bonds are generally taxed at your normal income tax rate. However, interest earned from some federal, state or municipal government bonds may not be subject to taxation. These so-called "tax-free bonds" can be a bit confusing because they are not all exempt from all income taxes. For example, interest from municipal bonds is typically exempt from federal taxation but may still be subject to your state and local income taxes.

With all the different ways a dividend fund can impact your annual taxes, it is important to consult your financial advisor before investing to ensure you know exactly what to expect come tax season.

Your Investment Goals

There are numerous options when it comes to choosing a mutual fund that pays high dividends, so finding the fund that is right for you takes some thought. When choosing a fund, examine your investment goals carefully and decide what level of risk you are willing to accept to achieve those goals.

You must decide if you would rather earn the highest possible dividend or settle for a more moderate annual distribution in exchange for long-term capital gains. Mutual funds managed with the goal of creating the highest possible yield often include a substantial number of stocks or junk bonds, both of which are inherently risky, and require a very active manager who trades assets frequently to generate the maximum amount of dividend income. This management style may mean a higher expense ratio, which can outweigh the benefits of dividend payments.

If your primary goal is to create regular income but you also want to minimize the tax impact of your investment, you need to discuss with your advisor which dividend funds are the most tax-efficient. This means finding a fund that employs a buy-and-hold strategy to minimize the fund's turnover ratio and generate dividend income that is more likely to be taxed at the capital gains rate. Funds that include government and municipal bonds are also tax-efficient options.

High-dividend mutual funds may seem like low-hanging fruit, but there are a number of factors to consider when investing in this type of security. Before jumping into any investment, consider what your goals are aside from the creation of dividend income. A solid understanding of how dividend funds work and the impact they can have on your finances goes a long way in helping you to select a fund that properly aligns with your objectives.

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