Depending on the type of investments included in the portfolio, mutual funds may pay dividends, interest, or both.

Types of Mutual Funds

There are four main categories of mutual funds, and each category suits different investing goals. Stock funds include only investments in the stock market. If any of these stocks pay dividends, then the mutual fund also pays dividends.

Similarly, bond funds include only investments in corporate and government bonds. Most bonds pay guaranteed amounts of interest each year, called coupon payments. Because bonds pay interest, bond funds do as well.

Balanced funds invest in stocks and bonds. Balanced funds, therefore, are almost guaranteed to pay interest, and they may also pay dividends depending on the specific stocks included in the portfolio.

Money market funds are considered the most stable type of mutual fund and include only investments in very short-term debt instruments such as municipal bonds. Money market funds also pay interest, though the rate of return is generally lower than other fund types.

Why Do Mutual Funds Pay Dividends and Interest?

To avoid paying taxes on investment income, mutual funds are required to distribute almost all proceeds to shareholders. This means that when a stock or bond within the fund's portfolio pays dividends or interest, that money must then be distributed to the fund's shareholders so the fund is not required to include it as income. Individual shareholders then report that investment income on their taxes for the year. The same is true if the fund makes a profit from the sale of an asset, called a capital gain.

The timing of mutual fund distributions, including dividend and interest payments, is at the discretion of each individual fund and can vary widely. Generally, funds that generate dividends or interest must make distributions to shareholders at least once a year.

Advisor Insight

´╗┐Dan Stewart, CFA®
Revere Asset Management, Dallas, TX

Mutual fund distributions are classified according to the type and character of the distribution. Thus, mutual funds can pay interest, dividends, and/or capital gains via distributions, which will determine the amount of tax you have to pay.

A bond fund, for instance, will typically pay interest, but also capital gains when the bonds are sold. A balanced fund holds both stocks and bonds, and therefore you can have all three types of distributions.

The reason for this is because a mutual fund simply passes through the distributions it receives from the securities, so as not to incur double taxation (at the fund level and then to the shareholder). If your investments are held in an IRA or another retirement account however, the tax consequences are irrelevant since they are tax-deferred.