To Pick the Right Dividend Fund, Learn How They Work

Think about it: The S&P 500 currently has a 1.8% dividend yield. The average equity fund carries a 1.4% expense ratio. It's simple subtraction, folks -- a fund with an average expense ratio and average yield could leave you with a 0.4% dividend payout.

Keep in mind, though, that high dividends mean higher taxes. Unlike capital gains, which have a lower rate structure, dividends are taxed at the investor's ordinary income tax rate. In other words, if you're in the 30% tax bracket, your dividends will be taxed at 30%.

The tax isn't withheld by the fund company; rather, the fund shop will send you a 1099-DIV in January, giving you a breakdown of the type of dividends and other distributions paid during the prior tax year. The Form 1099-DIV you get for tax year 2002 will include a dividend received in January 2003, as long as it was declared and was payable in the last quarter of 2002. You'll owe the tax on all dividends when you file; however, if you're collecting big dividend payouts throughout the year, you should consider making quarterly estimated tax payments to avoid an underpayment penalty come filing time. (The frequency of dividend payments depends on the fund; anywhere from once a month to once a year. Again, check the fund's prospectus to find out how often dividends are paid.)

Regardless of what type of dividend-paying securities the fund holds, investors can collect that income in one of two ways: They can either take the money and run (the mutual fund will send a check or directly deposit the amount of the dividend distribution) or they can reinvest the money in the fund (essentially using the dividends to purchase new shares). You'll make that decision when you first invest in the fund, but you can generally change your decision at any time.

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