Do Mutual Funds Pay Dividends?

Not all mutual funds pay dividends, but most do.

Mutual funds allow investors to invest in many types of securities – including stocks and bonds. And one of the critical sources of return to investors is dividends.

Mutual funds don’t generate dividends as companies do, but the constituent securities they hold in their portfolio generate dividends. So, if a mutual fund owns a dividend-paying stock, those dividends will eventually be distributed to the fund’s shareholders as dividends.

In addition to distributions of constituent security dividends, mutual funds may also pay dividends from their internal capital gains. This occurs when mutual funds sell some of their securities – this can result from active trading on the part of the fund managers to generate returns, portfolio rebalancing to maintain ideal security weights, or meeting redemption requests from other shareholders. These capital gains are then distributed to shareholders as dividends.

Mutual funds may also pay dividends from another source – return of capital. This occurs when a mutual fund’s expenses and distributions exceed the income/capital gains generated by the fund. Some of the shareholder’s original investment may be returned as dividends in these cases.

Depending on the type of fund you purchase, the quantity and frequency of those payments can vary dramatically.

In this article, we’ll examine mutual fund dividends, how they are taxed, and how you should view a fund’s dividend yield within your total investment plan.

This article was submitted by Jorge Sanchez, M.D.

 

What is a Mutual Fund?

A mutual fund is a collective investment that pools investor dollars to purchase a basket of securities like stocks or bonds. These funds are generally managed by professional money managers, who invest the fund’s assets to attempt to produce the highest risk-adjusted returns for the fund’s investors, given the fund’s particular strategy.

When you buy a share in a mutual fund, you become a part owner of all the investments in the fund and the income they generate. By owning shares in the mutual fund, you participate proportionally in the gains or losses of the fund.

A significant benefit of mutual funds is that they allow individual investors to invest in a diversified portfolio of stocks and equities with one purchase. If some holdings in the fund experience a loss, the impact on the investor’s capital can be offset by assets with gains.

Different types of mutual funds exist, including money market funds, bond funds, and stock funds. Each type of fund carries different features, risks, and rewards. Further, mutual funds carry costs in management fees and possibly sales commissions, regardless of the return. An easy way to determine the estimated operating costs required for a mutual fund is to look at the expense ratio which represents annual operating costs as a percentage of fund assets.

 

 

What Are Dividends?

Dividends are payments made to a company’s shareholders, usually derived from that company’s profits.  When evaluating a company’s financial health and lifecycle maturity, dividends are one of the primary metrics.

Historically, cash dividends have been seen as the primary method to reward shareholders for owning a company’s stock.  Other methodologies include share buybacks and stock dividends. However, cash dividends remain the most common method for companies to periodically and consistently return value to shareholders

 

How do Mutual Funds Pay Dividends?

Some companies pay dividends annually, but many pay them at other regular intervals, including quarterly and semiannually. Irregular dividends are also not entirely uncommon.

Although many companies try to adhere to a schedule of dividends based on internal policies, performance can also affect the size and frequency of dividend payments.

As opposed to interest payments on bonds, until declared, dividends are not direct obligations of the issuing companies. Therefore, they are not guaranteed – they can be increased, decreased, or suspended by a company’s board.

Generally, dividend payments are also subject to taxation – we will discuss later in the article how the taxability of dividends can change depending on the situation.

 

How are dividend payments calculated?

Mutual fund dividend payments are calculated similarly to traditional dividend payments on a stock.

Total Dividend Payments / Total Mutual Fund Shares = Dividend Payment per Share

Dividend Payment Per Share x Investor Number of Shares in the Mutual Fund = Total Dividend Payment for Investor

Example: A mutual fund received $100,000 in dividend payments for one quarter. Assuming that the mutual fund issues 1,000,000 shares, the mutual fund would issue a $0.10 dividend payment per share. If you own 1,000 shares of the mutual fund, you will receive a $100 dividend payment for that quarter.

Mutual funds will publish their dividend payments and keep a historical record. Below is the dividend payment table of the last four quarterly payments for the Vanguard High-Yield Dividend ETF.

 

 

The Vanguard High Dividend Yield ETF (VYM) is an all-stock fund that drives shareholders as much income as possible while remaining diversified across market sectors. As of when this article was written, VYM has a trailing dividend yield of 3.09% annualized,  and the fund pays its dividend quarterly – after aggregating individual dividend payments from 462 individual stock holdings.

Let’s apply the formula we discussed above to the VYM Fund. The most recent payment of $0.8767 per share was delivered to fund holders of record as of June 21st. So if you held 100 shares of VYM, you’d have received $87.67 on June 23rd.

 

How Are Mutual Fund Dividends Distributed and Taxed? (IRS 1099-DIV)

As previously noted, dividends may be paid out at different periodic intervals. The same is true of mutual fund dividends. Those payments may be monthly, quarterly, or annually.

Mutual fund investors typically have the chance to declare whether (1) they want to receive their dividends as cash payouts or (2) reinvest them in more shares of the mutual fund. Since mutual funds typically allow fractional share purchases, automatic reinvestments are seamless.

Mutual fund dividends are subject to taxation at varying levels depending on a few criteria. Of course, if the mutual funds are held in a tax-deferred account (such as a retirement account), there will be no tax consequences when dividends are issued/received. However, if the mutual funds are held in taxable accounts, dividends can be taxed in one of three ways:

1. Ordinary Dividends: Dividends distributed from the mutual fund’s income that does not qualify as qualified dividends. In taxable accounts, ordinary dividends are taxed as ordinary income at the shareholder’s marginal tax rate.
2. Qualified Dividends: Under certain circumstances (including how long a mutual fund or specific constituent security has been held). Although qualified dividends are derived from the same source (fund performance) as ordinary dividends, qualified dividends receive tax advantages. They are typically taxed at the federal level at a rate ranging from 0% to 23.8%, depending on the shareholder’s unique tax situation.
3. Capital Gains Dividends: Dividends from internal capital gains within the mutual fund (trading going on within the fund either for active reasons or to maintain appropriate balances). Taxed at the same rate – ranging from 0% to 20%, depending on the shareholder’s income level

Mutual fund dividends are not only subject to federal taxes – depending on the state and city where the shareholder lives or where the mutual fund is registered, other taxes may apply. Most states and municipalities that levy a state or local income tax do not differentiate between ordinary income and investment income, including dividends.

 

How to Find High-Dividend Mutual Funds

When evaluating a mutual fund’s dividend-paying capacity, you should look for several metrics.

•       Dividend Yield: This reflects the total dividends per share represented as a percent of the fund’s price on an annualized basis. The higher the yield, the higher the dividend. All else equal, high dividend yield is seen by many to be “better”, but a higher dividend yield can signal an overly mature business with low growth potential or even a high-risk investment.
•       Expense Ratio: Given that dividends are paid out after the expenses from a fund, investors looking for high-dividend funds should also pay attention to expense ratios (the metric reflecting the operating costs of a fund on an annual basis). Lower expense ratios equal more income left for distributions.
•       Turnover Ratio: The turnover ratio reflects the percentage of a portfolio bought/sold annually. Higher ratios equate to more trading activity. More trading activity is then associated with more capital gains from internal trading and, thus, more potential taxes.
•       Fund Holdings by Industry: Some industries – such as real estate (REITs) and Natural Resources pay higher dividends on average. Thus, high dividends associated with such funds shouldn’t always be seen as red flags indicating a low-growth investment

Below, I have listed some high-dividend mutual funds that are quite popular across some main categories:

• Vanguard High Dividend Yield Index Fund (VHDYX):
  • Dividend Yield: 3.01%
  • Expense Ratio: 0.06%
  • Turnover Rate: 11%
  • 10-Year Performance: 10.97%
• Fidelity Equity Dividend Income Fund (FEQTX):
  • Dividend Yield: 2.77%
  • Expense Ratio: 0.59%
  • Turnover Rate: 38%
  • 10-Year Performance: 11.54%
• T. Rowe Price Dividend Growth Fund (PRDGX):
  • Dividend Yield: 1.42%
  • Expense Ratio: 0.62%
  • Turnover Rate: 29%
  • 10-Year Performance: 14.33%
• Schwab US Dividend Equity ETF (SCHD): This fund tracks the performance of the Dow Jones U.S. Dividend 100 Index, which consists of foreign stocks that pay high dividends. The fund has a yield of 3.12%, an expense ratio of 0.06%, and a turnover rate of 13%. The fund has returned 8.69% annually over the past 10 years.
  • Dividend Yield: 3.12%
  • Expense Ratio: 0.06%
  • Turnover Rate: 13%
  • 10-Year Performance: 8.69%
• SPDR Portfolio Emerging Markets Dividend ETF (SPYD):
  • Dividend Yield: 4.32%
  • Expense Ratio: 0.11%
  • Turnover Rate: 28%
  • 10-Year Performance: 7.64%

 

What are the Advantages of Investing in Dividend Mutual Funds?

 

Steady Stream of Income

One benefit of dividend mutual funds is that they are designed to deliver a dividend payment consistently. For many dividend funds, this payment is distributed quarterly. By investing in a dividend mutual fund, you can give yourself a steady stream of income.

The amount of income you receive depends on the amount of shares you purchased from the mutual fund. The higher your initial investment, the larger your income stream of dividend payments will be.

Mutual funds publish a record of historical dividend payments. Using historical dividend payments, you can get a good idea of how much you earn based on the number of shares you purchase.

 

Less Volatile Than Many Stocks

One great thing about dividend mutual funds is that they tend to be less volatile than the stock market. Since dividend mutual funds target stocks of companies that are stable, have consistent dividend payments, and have consistent cash flow, these companies are generally less volatile than the rest of the stock market.

As a result, dividend-paying mutual funds are often less volatile than the rest of the stock market. Another important factor is that dividend mutual funds are less affected by bearish markets. Dividend mutual funds often outperform during bear markets because they invest in dividend stocks of companies less affected by economic downturns.

 

Tax Benefits with Retirement Accounts

Investing in a mutual fund using your retirement account, such as your IRA or 401(K) is a great way to take advantage of the tax benefits.

Specifically, dividend payments are not taxed when received or withdrawn with a Roth retirement account. This means that the income generated from your dividend mutual fund would be 100% tax-free. While it would be tax-free, it’s important to note that you must follow your retirement accounts withdrawal rules, which require you to wait until retirement age before withdrawing that income without penalty. However, it should be noted that the opposite is true with respect to taxable accounts – as opposed to mutual funds focused more on capital appreciation as opposed to dividend yield, dividend mutual funds create frequent periodic tax obligations from their dividend payouts – making them a tax-inefficient vehicle for taxable accounts,

 

What are the Disadvantages of Investing in Dividend Mutual Funds?

 

Tax Inefficiency in a taxable account

Dividends generate periodic tax obligations over the term of an investment (which annually appear on your 1099s), whereas capital gains tax obligations only accrue when a mutual fund is sold. Therefore, funds focused more on capital gains than mutual funds are advantaged from a tax perspective when they sit in a taxable account due to the inherent tax deferral advantages of capital gains vs. paid dividends.

 

There is no free lunch

There is conflicting evidence on whether or not dividend-focused funds offer a higher risk-adjusted total return, and evidence that supports the idea tends to suffer from survivorship bias. 

Any list of companies consistently increasing their dividends for decades will show strong past returns. It’s not just a list of survivors but of winners. 

Evidence of an increased total return for dividend-focused funds total return tends to disappear when controlling for value and quality. Higher dividends result in a  lower after-tax return in a taxable account when compared to a low or no dividend fund, assuming an equal total return. 

Many investors see dividends as “free money”, but what these investors also need to understand is that dividends are simply a choice made by companies to return value directly to shareholders instead of accumulating value in the company in the form of capital gains.

For example, when a company declares and is about to pay a dividend, the share price will often rise as long as the dividend amount is equal to or better than anticipated by investors – in this case, the stock is said to trade cum dividend.

However, when the ex-dividend date is reached (the date at which the shares stop trading with a dividend included in the value), the share price falls by precisely the amount of the dividend to be paid. 

While not perfectly representative and ignoring some additional complexity, this serves to illustrate how dividends and capital gains are seen more or less as a 1 to 1 tradeoff by the financial markets; thus, much financial theory suggests that investors should steer away from pursuing dividends at the expense of capital gains when they can simply be considered a comparable form of return.

 

Adds complexity

Do you balance out with growth funds? Low dividend funds? These questions add complexity to a portfolio that doesn’t need to be there. Many financial professionals rather simply recommend total stock funds, for example, which contain dividend-paying securities, but don’t necessarily focus on them to the detriment of other fund types.

 

Conclusion

Mutual funds are a great way for investors to diversify their portfolios. The underlying securities within mutual funds pay dividends.

Those dividends and other cash flow sources generated within the funds are eventually distributed to mutual fund investors. I described above how these dividends are taxed differently depending on several characteristics, including how long the underlying securities paying the dividends were held in the mutual fund.

There are undeniable benefits to holding high-dividend mutual funds. They offer a diversified approach to investing in a somewhat regular income stream  to investors and, in some instances, surprisingly good capital appreciation benefits. Remember, unlike interest payments, dividends are not direct obligations of the issuing firms; thus, there is always a risk of dividend cuts.

Therefore, you should do your research and due diligence before investing in any mutual fund, especially those that pay high dividends. When choosing mutual funds, you should also consider your financial goals, risk tolerance, time horizon, and tax situation.

This article does not intend to provide any financial advice or recommendations; you should consult a professional before making any investment decisions.

 

FAQ

 

What’s the difference between record date, ex-date, and pay date?

The record date, ex-date, and pay date are all dates that are important when receiving a mutual fund dividend.

The ex-date is the date when a mutual fund starts trading without the value of the next dividend payment that had been previously declared. If you buy a dividend on or after the ex-date, you will not receive the most recently declared dividend. Usually, the ex-date is one business day before the record date.

The record date is when a company identifies all current shareholders and everyone eligible for a dividend payment. The company or mutual fund typically sets this day. The record date is typically one day after the ex-date. You must own the share before the record date to receive the declared dividend payment.

The pay date is when the declared dividend is disbursed to shareholders. This date is typically decided by the company issuing the dividend and can be up to 1 month after the ex

 

How to Invest in Dividend Mutual Funds?

 

If you want to invest in mutual funds yourself, you will have three options:

1. Brokerage account – purchase mutual fund shares from a brokerage account. A brokerage account will give you access to a variety of mutual funds. High-income individuals, like many doctors, should be hesitant about using this strategy because dividend mutual funds generally consistently generate meaningful periodic tax consequences that would be better held in non-taxable retirement accounts.
2. Retirement Account such as IRAs or 401(K)s – You can purchase mutual funds using your retirement accounts. It’s important to note that specifically within a 401(K) you may have a limited selection of mutual funds compared to a brokerage account.

 

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