When selecting a mutual fund, an investor is faced with a number of big choices. Among the more confusing decisions is the choice between a fund with a growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which is a better fit will depend on your individual needs and circumstances as an investor.
Mutual Funds with a Growth Option
The growth option on a mutual fund means that an investor in the fund will not receive any dividends that may be paid out by the stocks in the mutual fund. Some shares pay regular dividends, but by selecting a growth option, the mutual fund holder is allowing the fund company to reinvest the money it would otherwise pay out to the investor in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund. The growth option is not a good one for the investor who wishes to receive regular cash payouts from his/her investments. However, it's a way to maximize the fund's NAV and, upon sale of the mutual funds, realize a higher capital gain on the same number of shares he/she originally purchased. This is because all dividends that would have been paid out have been used by the fund company to invest in more stocks and grow clients' money. In this case, the investor does not receive more shares, but his/her shares of the fund increase in value.
Mutual Funds with a Dividend Reinvestment Option
The dividend reinvestment option is quite different. Dividends that would otherwise be paid out to investors in the fund are used to purchase more shares in the fund. Again, cash is not paid out to the investor when dividends are paid on the stocks in the fund. Instead, cash is automatically used by the fund's administrators to buy more fund units on behalf of the investors and transfer them to individual investors' accounts. This method increases the number of shares owned over time and typically results in the account growing in value at a faster rate than if dividends were not reinvested. Many investment companies offer this service to shareholders at no cost.
Investors realize a capital gain upon the sale of their units in the fund, which in the case of the dividend reinvestment option will probably be more fund units than they started with.
Selecting a Dividend Distribution Option
In most cases, it is up to shareholders whether they prefer to have dividends reinvested or paid out. An exception to this would be in the case of individual retirement accounts (IRAs). Dividends in IRA accounts must be reinvested by shareholders who have not yet reached retirement age so they do not incur early withdrawal penalties from the Internal Revenue Service (IRS).
In a dividend payout scenario, dividend distributions made by the mutual fund are paid out directly to the shareholder. If the shareholder chooses this option, dividends are usually swept directly into a cash account, transferred electronically into a bank account or sent out by check. As is the case with the dividend reinvestment option, shareholders in most cases incur no fees for having their dividends paid in cash.
Choosing to reinvest dividends or have them paid out does not affect the tax implications of those dividends. From a tax perspective, dividend distributions are treated identically in either situation.
The Bottom Line
No single mutual fund is perfect for every investor; that's why there are so many out there with so many different options. When investing in a mutual fund, it's best to examine its specific attributes to avoid investing in a fund that doesn't suit your unique requirements for growth or cash payout.