Richard Loth has 40+ years of experience in banking, corporate financial consulting, and nonprofit development assistance programs.
Updated May 10, 2022Mutual funds can realize net capital gains when they receive dividends or interest from the assets they hold and make profitable sales of portfolio assets. The fund can, in turn, return some or all of these gains to investors in the form of dividends and distributions. When a fund issues a distribution, the shareholders can either elect to be paid directly—putting the money into their account—or elect to buy more shares of the fund—known as reinvesting.
Whichever scenario mutual fund shareholders choose, they either benefit from $100 paid to them in cash or $100 reinvested in additional shares of the ABC Fund. If you are living off investment income, you will choose one of the dividend payout alternatives. If you are building a retirement nest egg, you will choose to plow that dividend back into more shares of the fund and enjoy the long-term benefits of compounding your investment.
For example, let's say the ABC Fund makes a quarterly income distribution of $100 as a dividend to shareholder Mary Smith. If the fund company has a money market fund, Mary could put the $100 there, which keeps it liquid and at her immediate disposal. The $100 could be sent to her by check or deposited into her bank account.
In all of these instances, Mary gets to use the dividend amount any way she pleases. As an alternative, she can elect to reinvest the $100 dividend payment in more shares of the ABC Fund. Generally, this is done through automatic dividend reinvestment instructions established by Mary and automatically executed by the fund company for her account. The dollar amount of her investment in the fund will increase by $100.
By law, mutual funds must pay out income and realized capital gains to the funds' shareholders. These distributions come from a fund's assets, which is why a fund's net asset value—and therefore its price—drops accordingly.
Though a profit from any investment is a good thing, it carries a substantial tax burden as well. Unless the income comes from a tax-free fund—like a muni bond fund—all income received from the fund must be included in shareholders' taxable income.
Russell Wayne, CFP®
Sound Asset Management Inc., Weston, CT
When a mutual fund declares a distribution, the fund price drops by a similar amount, but you aren't losing money as a result. You’ll receive the distribution in cash, which you may reinvest in additional shares of the fund.
The distribution may or may not benefit you. If the fund has been successful and the NAV is growing, that would be a good sign. But the distribution may be reflective of gains built up over time that are just now being realized. That could be cause for concern. It is more useful to focus on changes in the fund's NAV and how those changes compare to the fund's benchmark. If, for example, the fund invests in a broad range of U.S. stocks, the benchmark might be the Standard & Poor's 500 Index. If the NAV returns were better than those of the S&P, that would be good.