The Ins and Outs of Dividend Mutual Funds: How They Work and Beyond

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. Dividend mutual funds mainly invest in companies that pay dividends. These are profits that companies split with stock shareholders. 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, while mutual funds diversify risk by holding potentially hundreds of different investments.

Here’s what you need to know about mutual fund dividends, along with reasons why you might want to add a mutual fund to your portfolio:

Mutual Fund Dividend and Return Characteristics

Most dividend stocks pay on a quarterly schedule, and a mutual fund that holds 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.

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What Happens to Dividends in a Mutual Fund?

By law, a mutual fund is required to pass profits back to the investor or shareholder, and dividends represent a portion of profits for dividend-paying stocks. A dividend mutual fund pays the distributions, or income, after expenses.

Dividends are passed back to the investor in one of three forms: as an ordinary dividend, as a qualified dividend or as capital gains. The difference between the three ultimately boils down to the tax implications of the dividend payment, which is treated like income earned through work. Dividend mutual funds pay out a dividend at regular intervals to their fund holders.

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What Is the Best Dividend Mutual Fund?

Determining the best dividend mutual fund depends on your financial situation, as well as the current economic climate. No one mutual fund is “the best” to buy for every single investor. The best mutual fund for you will be one that meets your investment objectives, has low fees and performs well over long time periods. You can research different fund performances on your own or hire an investment professional to help you find the right one.

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Dividend Mutual Fund Risk Characteristics

Companies that pay dividends usually have consistent cash flow. To reach this point, they are often mature companies with predictable earnings streams. This can make dividend stocks less volatile than newer, more aggressive companies, which makes dividend mutual funds appealing 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.

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How Is Dividend Calculated in a Mutual Fund?

Dividends for a mutual fund are calculated like this: On the fund’s record date, the fund manager, whether active or passive, will total all the profits from a reporting period — the dividends in this case — subtract all necessary costs and fees and then divide the remaining amount by the total number of shares in that particular fund.

For example, if the investor has 200 shares in the fund, and the fund provides a $3 distribution per share, the investor will receive $600 for that reporting period.

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How Dividend Mutual Funds Are Taxed

As stated previously, 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% and might even 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.

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What Are the Advantages and Disadvantages of Dividend Mutual Funds?

When deciding whether a dividend mutual fund is the right fit for your investment strategy, it’s always wise to consider the pros and cons. The biggest advantage of this type of investment centers mostly on its functionality and risk assessment. Dividends from these funds can serve as a source of income or be used to purchase more shares of the mutual fund. They also tend to be much less aggressive.

The biggest disadvantage of a dividend fund — and its biggest advantage — is the income it produces. On the plus side, you’re getting income. On the downside, dividend mutual funds are taxed as ordinary income. Another disadvantage is that your returns on a dividend mutual fund might be less than those of a more aggressive fund.

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How Do I Know If Dividends Are Qualified?

To assess whether dividends are qualified or not, use this basic formula: If the shares are owned for more than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date, the dividend is qualified.

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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.

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This article has been updated with additional reporting since its original publication.

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About the Author

After earning a B.A. in English with a Specialization in Business from UCLA, John Csiszar worked in the financial services industry as a registered representative for 18 years. Along the way, Csiszar earned both Certified Financial Planner and Registered Investment Adviser designations, in addition to being licensed as a life agent, while working for both a major Wall Street wirehouse and for his own investment advisory firm. During his time as an advisor, Csiszar managed over $100 million in client assets while providing individualized investment plans for hundreds of clients.