Key Takeaways
- Dividend mutual funds are mutual funds that invest in stocks that pay dividends.
- You can then reinvest the dividends into more shares of the funds, or you can use the money as an income stream.
- A DRIP plan enables you to reinvest dividends to buy more of the same stock.
- You must pay taxes on dividends from these funds as ordinary income, in most cases, even if the dividends are reinvested.
Definition and Example of Dividend Mutual Funds
Dividend mutual funds hold stocks of publicly traded companies that pay regular cash dividends, generally every fiscal quarter.
If you own stocks of dividend-paying companies through a mutual fund, the dividends will be paid to the fund, which will pass that money along to its investors.
Dividend mutual funds tend to own shares of established companies. They often have a long history of paying dividends. These stocks are often referred to as "blue-chip stocks."
When companies offer a dividend on their stock, they base it off a percentage of the cost for one share of stock. The more shares of stock you own, the higher your dividend will be.
How Do Dividend Mutual Funds Work?
Some dividend mutual funds focus on stocks that pay high dividends that represent a large percentage of their stock price. That percentage is known as "dividend yield." Here's how you can find it. First, divide the annual payout by the share price, and then multiply by 100.
For instance, suppose a stock pays a dividend of 60 cents per share each quarter. It trades at $42 per share. That means its annual dividend payout would be $2.40. When you divide that figure by $42 and multiply it by 100, you arrive at the dividend yield: 5.71%.
The names of these funds might include phrases like "dividend yield" or "high dividend."
Note
In late 2022, the dividend yield of the Standard & Poor's 500 was 1.82%. The long-term average is 1.85%.
Other dividend mutual funds focus on stocks that are increasing the amounts of their dividends. These funds might include phrases like "dividend growth" or "dividend appreciation" in their names.
A dividend mutual fund may invest according to an index that tracks companies that have high dividend yields or those that have a history of increasing their dividends. For instance, the Vanguard High Dividend Yield Index Fund (Admiral Shares) seeks to mimic the return of the FTSE High Dividend Yield Index.
When looking into dividend funds, assess their yields based on two methods:
The 30-day SEC yield reflects the dividends paid during the 30 days that ended on the last day of the last month; this is after you deduct the fund's expenses.
A mutual fund's trailing-12-month (TTM) yield refers to the percentage of income the fund returned to investors during the past 12 months. In the case of a stock mutual fund, income consists of dividend payments.
Alternatives to Dividend Mutual Funds
Exchange-traded funds (ETFs) are like mutual funds that are traded like stocks. Their prices change often throughout the trading day, in contrast to mutual funds. ETFs are meant to reproduce the performance of an index of stocks. And like dividend mutual funds, some of them aim to mimic an index of stocks known for paying high or increasing dividends. For instance, the iShares Core Dividend Growth ETF seeks to match the performance of the Morningstar US Dividend Growth Index.
Note
Mutual funds and ETFs that seek to mimic an index's performance tend to have lower fees than funds that are actively managed. The funds' managers choose their investments using a screening process, which is in contrast to passive buying simply because they're in the benchmark index.
Dividend reinvestment plans (DRIPs) allow you to buy more shares using your dividends. You can even buy fractions of a share. Some companies let you invest in their stock directly without using a broker, and many online brokers will set up a DRIP for you free of charge.
Pros and Cons of Dividend Mutual Funds
Pros
Offer a steady stream of income
Perform better in a bear market
Cons
Tend to be outpaced in a bull market
Taxed as ordinary income
Pros Explained
Offer a steady stream of income: By paying investors at regular intervals, dividend mutual funds offer a steady stream of income.
Perform better in a bear market: When a bear market occurs, trading is down. In a bear market, dividend funds tend to do better than mutual funds that look for stocks with quickly rising share prices ("growth stocks").
May have favorable tax treatment: Qualified dividends (those that meet IRS requirements) are taxed at the lower long-term capital gains tax rate.
Cons Explained
Tend to be outpaced in a bull market: In a bull (up) market, dividend funds will likely be outpaced by growth-focused mutual funds.
May be taxed as ordinary income: Ordinary dividends are those that don't meet the requirements to be considered qualified dividends. These are taxed as ordinary income, often at a higher rate. Although most mutual funds seek qualified dividends, those that hold dividends that aren't qualified won't receive the lower capital gains tax rate.
Frequently Asked Questions (FAQs)
What are the tax advantages of dividend mutual funds?
One way to take advantage of dividend mutual funds is to hold them within tax-advantaged retirement accounts, such as an IRA. That lets you defer taxes until you take distributions. If you hold shares of these funds in a regular brokerage account instead, the dividends will be taxed as ordinary income unless they are qualified dividends. If they're qualified dividends, they'll be taxed at the capital gains rate.
What are the best dividend mutual funds?
The best dividend mutual funds combine quality stock picks and attractive dividend yields with lower expense ratios. Look for funds that will let you balance above-average yield with your personal risk tolerance.
