We’ve all heard the stories—a friend gets a hot tip and buys stock in a small company, times the purchase perfectly, and it goes up in value three-fold over the next several years.
While it makes for good drama (and perhaps some mild envy), a portion of the gains achieved by mutual fund investors come from a less exciting source—recurring distributions. These provide current income to an investor and are made up of dividends and capital gains. So even if the shares don’t appreciate greatly in value, they can still be profitable.
What are dividends?
For a publicly traded company, a dividend is a cash payment to all investors who hold shares of stock in the company. These cash payments are typically a fixed amount per share and are issued at regular intervals (often quarterly).
When talking about dividends, they are often referred to as the yield or percentage relative to the stock price. Here’s an example:
$100 Stock price
$5 per share Annual dividend
5% Dividend yield ($5 ÷ $100)
Let’s say that the price dropped, but the dividend remained at $5 per share—dividends often remain constant and are changed only by a decision of the board of directors. The dividend as a percentage of the stock price would increase:
$90 Stock price
$5 per share Annual dividend
5.5% Dividend yield ($5 ÷ $90)
Companies that pay higher dividends are typically from more conservative, lower growth industries such as utilities, financial services and real estate. Younger, faster growing companies—like those in the technology sector—frequently choose to keep their cash and reinvest it to accelerate the growth of their business rather than returning the cash to shareholders in the form of dividends.
To compare, if you invest in a bond, you’ll receive interest payments instead of dividends from the bond issuers. “Issuers” are typically corporations, municipalities—like cities and towns—or state and federal governments that use bonds to finance operations and projects. The issuer pays interest to bondholders based on a percentage of the face value or principal of the bond.
The term “coupon rate” typically refers to the annual interest rate stated on the bond. For example, if a $1,000 bond has a 5% coupon rate, the bond issuer would pay the bondholders $50 (or 5%) of the face value of the bond each year until the bond reaches maturity.
Putting dividends to work in your mutual funds
When you invest in a mutual fund, the fund may own a wide array of stocks and bonds that may pay dividends and interest. The mutual fund consolidates all the dividends and interest and periodically pays it out to you, the mutual fund investor—although there is no guarantee that dividends will be paid in any year. Dividends may be paid monthly, quarterly or annually, and the amount paid each time may vary depending on the fund and its underlying investments.
As a mutual fund shareholder, you can choose how dividend distributions are handled. You may choose to have them paid to you in cash (this may be helpful to supplement retirement income) or you could elect to reinvest them. Reinvesting dividends increases the number of shares you own without investing any additional cash. With a Thrivent Mutual Funds account, you can set this up to happen automatically.
Without dividend reinvestment, the only way for your account balance to grow would be to make additional purchases into it, or if the price of the stocks and bonds held in the fund increases.
Capturing returns with capital gain distributions
Mutual funds regularly buy and sell securities in their portfolios based on the decisions their portfolio managers and analysts make to meet fund objectives. This activity can result in capital gains (and sometimes losses). The gains are then passed along to mutual fund shareholders in the form of capital gain distributions.
Mutual funds are required to pay out any capital gains the portfolio has realized each year to its shareholders. Like dividends, capital gain distributions can be made in cash or reinvested into your account.
The rest of the story
While increasing share prices can be exciting, they are only part of the story. To get a complete picture of how well a mutual fund is performing, investors need to look at both the potential for growth as well as income.
That’s why learning how stock and bond mutual funds distribute dividends and how they can boost your potential earnings is a crucial step to becoming a more informed, confident and successful investor.
How are dividends and capital gains taxed?
When mutual fund shares are held in a taxable account (not an IRA, Coverdell ESA or similar tax-advantaged account), any dividends or capital gains that are paid out become taxable to the shareholder and are treated as if the shareholder owned the underlying security directly. So, dividend distributions from a mutual fund are taxable to you as ordinary income and capital gain distributions are usually taxable as capital gains.
The only exception to this would be if you owned the fund in a traditional or Roth IRA or other tax-deferred type of account and are reinvesting the dividends and capital gains so you do not have a tax impact in the year they are reinvested. (Learn more about the difference between an IRA and Roth IRA.)
These types of funds may invest in municipal securities that are subject to state and local taxes and/or the alternative minimum tax (AMT). While the dividends earned on a municipal bond fund are usually federally tax-exempt, any capital gains distributions, as well as realized capital gains from selling fund shares, may be taxable.
Also, if you own a municipal bond fund, you may avoid taxes on dividends because the dividends are typically free from federal and sometimes state income tax.
As always, be sure to consult with your tax professional for more detailed information on the tax treatment of dividends and capital gains in taxable and tax-deferred accounts.
