How Mutual Fund Distributions Really Work
Many investors know how stock-related dividend payouts work, but what if those income equities are being held in a mutual fund?
A lot of investors love owning companies that pay dividends and for good reason: It’s money that can be used to either buy more units within their mutual fund or to supplement their income stream.
All dividend income flows into a mutual fund and then it’s a matter of whether that mutual fund distributes those dividends.
When it comes to stocks, the payout process is straight forward. You buy the stock and the company pays out a certain percentage of its earnings to shareholders. You can then either take the cheque or reinvest those dollars.
But what happens to dividends paid into a mutual fund? The process is somewhat different – mutual fund payouts are called distributions for one. We spoke to Nathalie Godbout, Vice-President Consulting and Support IG Investments, for more dividend details.
Frequently Asked Questions about Mutual Funds
Do all Mutual Funds pay a distribution?
No. Only if there is dividend income to be distributed. Many funds invest in companies that don’t have high dividend payouts or may not pay dividends at all. So in that case there may be nothing to distribute to clients. The funds that do pay are usually the ones with a dividend objective. What an investor decides to buy will depend on their own objectives which may include whether they want to own an investment that distributes income.
With Mutual Funds, it's the fund that owns the stock, not the investor. What does that mean for dividends?
That’s right. All dividend income flows into a mutual fund and then it’s a matter of whether that mutual fund distributes those dividends. When a fund receives dividend income some of that income is used to offset certain expenses related to operating the fund. Dividend-focused funds though, typically invest in companies that have higher payouts, which means that there’s still money left over for unit-holders after those expenses are paid.
Can investors decide whether to reinvest or receive a cheque?
Yes, they can. If they need the money they can ask to have the distributions paid out to them. Most dividend-focused funds will distribute quarterly. Retirees tend to use those dividends to enhance their retirement income. However, the default choice for many people is reinvestment. The money gets invested back into the fund so those dollars can compound and, ultimately, grow their income stream.
How can someone know what distribution a fund pays?
They can find that information on the company’s website or by asking their advisor. It’s like if a stock has a 2% yield. The fund will also say it has a 2% yield, or whatever the yield may be. Distributions can change depending on whether stocks in a fund change their payout policies, so it’s a good idea to look at a fund’s distribution history to see how consistent its payouts have been.
Dividends held outside of an RRSP or TFSA are taxed at a better rate than interest income. Is it the same with Mutual Fund distribution?
Tax must be paid on both forms of income. Even if you reinvest those dividends, you still have to pay tax, but it’s at a more favorable rate compared to interest income as you benefit from the dividend tax credit. Also, what you pay tax on is only based on what the mutual fund distributes to a unit-holder’s account. One thing to note is that foreign dividend stocks held in a mutual fund aren’t subject to the better tax treatment. You will end up paying tax on it like you would on a bond or regular income.
Are dividends right for everyone?
Not necessarily. You should own dividend funds if it’s part of your objective to enhance your income stream. If it’s not, then dividend funds may not be right for you.
Published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Consultant.