To Pick the Right Dividend Fund, Learn How They Work

Investors in it for the immediate income have already made the decision to collect the dividend payouts in cash, and will certainly owe income tax on the full amount. But investors willing to reinvest their dividends can avoid the tax if they keep the fund in a tax-advantaged account, such as a 401(k) or IRA. You'll still owe ordinary income tax on the amount you withdraw down the road, but won't pay tax annually on the dividend distributions.

NAV: Not an Appropriate Valuation

Sharp investors will notice that when dividends get reinvested in a fund, the shares that are purchased with the reinvested income are bought at a lower net asset value (NAV). That's because the act of paying out a dividend lowers NAV.

Look at it this way: If a fund has a $30 NAV before the distribution, then pays out $5 per share in dividends, the NAV drops to $25. If that $5 per share is reinvested, it will go to buy shares that have an NAV of $25. The total money invested in the fund, though, remains the same.

In this scenario, 100 shares at a $30 NAV amount to a $3,000 investment that pays out $500 in dividends. If you chose to reinvest those dividends, you'd essentially purchase 20 shares at $25 per share. So now you own 120 shares (your initial 100 shares plus the 20 the reinvested dividends bought), but your overall investment is still $3,000. And, of course, you'll owe tax on that $500.

But that's all just a mathematical exercise, Cooley says. "That's not an economic change at all and shouldn't factor into your decision as to whether or not to reinvest your dividends," he says. "NAVs aren't very helpful in evaluating investment options because they're so arbitrary. It's just a measure of the value of the fund's underlying holdings."