What Are Dividend Mutual Funds and How Do They Work?

Dividend-paying mutual funds are hybrid investment vehicles.

A dividend mutual fund could be the answer for anyone wondering how to invest for both growth and income. A dividend mutual fund holds a collection of stocks that pay dividends or regular distributions of a company’s profits. Both mutual funds and dividend-paying stocks might appeal to the same type of investors, as dividend stocks are typically high-quality companies that can ride out volatile stock market gyrations, and mutual funds diversify risk by holding potentially hundreds of different investments. Here is a look at what you need to know about investing in mutual fund¬†dividends, along with reasons why you might want to add one to your portfolio.

Mutual Fund Dividend and Return Characteristics

Most dividend stocks pay on a quarterly schedule. A mutual fund holding dividend-paying stocks is required to distribute this income to shareholders. Some funds pay monthly, whereas others pay quarterly or even annually. In addition to a regular income payout, dividend mutual funds have the potential for capital growth. For example, Apple, the largest company in the world by market capitalization, pays a yield of about 1.41 percent, but it also returned 48.24 percent in 2017.

Dividend Mutual Fund Risk Characteristics

Companies that pay dividends typically have a consistent cash flow. To reach this point, dividend payers are often more mature companies with a more predictable earnings stream. This can make dividend stocks less volatile than newer, more aggressive companies, which can make dividend mutual funds appeal to more risk-averse investors.

Some dividend mutual funds invest in companies known as “dividend aristocrats.” To qualify for this moniker, a company must be a member of the Standard & Poor’s 500 index and must have increased its dividend annually for at least the last 25 years. These companies have a record of paying rising dividends even through bad economic times, providing some level of assurance for investors.

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The Power of Reinvestment

When you invest in dividend mutual funds, you can either take the distributions in cash or reinvest them into more shares of the fund. Reinvested dividends can compound your returns over time, as you’ll be earning dividends on top of your dividends. For example, if you invest $10,000 in a mutual fund paying a 5 percent dividend, you’ll earn $500 per year. If you reinvest that dividend — assuming no growth in the underlying shares — you’ll have $10,500 after year one. The next year, you’ll earn $525, rather than the $500 you earned the first year. Over time, dividend reinvestment can be a significant portion of a fund’s overall return.

How Dividend Mutual Funds Are Taxed

Mutual funds can pay either ordinary or qualified dividends. Ordinary dividends are taxed at your regular tax rate, the same as your wages or salary. Qualified dividends receive a special tax rate of no more than 23.8 percent and might be tax-free. At the end of the year, a mutual fund company will mail you Form 1099-DIV which lists the amount of ordinary and qualified dividends you have received during the year.  

Dividend Mutual Funds: Caveats and Risks

Dividend mutual funds carry many of the same risks as individual stocks. You can lose money in dividend funds if the underlying stocks go down in value. Your income is also not guaranteed, as stocks can cut their dividends. Dividend mutual funds also carry costs. You might have to pay a commission to buy or sell a fund, and all funds have annual costs, expressed in the form of an expense ratio.

Related: Types of Mutual Funds