Everything old is new again, and as investors creep back into equities, more and more are interested in income, or dividend-paying, stocks. As with many aspects of equity investing, you can get the same benefits and better diversification through mutual funds.Dividend-paying mutual funds hold securities that pay dividends. The Internal Revenue Service requires that any income a fund gains through dividend-paying instruments in its portfolio must be passed on to investors. Those dividend-paying securities can be stocks, bonds, real estate investment trusts (REITs) or convertible bonds. Sussing out the best dividend fund for your needs, though, requires a bit more digging. "You really need to check the prospectus pretty carefully," warns Morningstar senior analyst Scott Cooley. "Just because a fund has 'dividend' in its name doesn't mean that you're going to get a lot of income." Take Fidelity's ( FDGFX) Dividend Growth fund, please. If you're looking for income, you might think a fund named "Dividend Growth" would provide lots of it. But the yield on this fund is a paltry 0.83% -- less than half the S&P 500's 1.8% dividend yield. As far as income goes, you'd be better off in an S&P index fund. A close reading of the prospectus explains why. The fund, according to the prospectus, "normally invests primarily in companies that pay a dividend or that it believes have the potential to pay dividends in the future." (You can find the prospectus on
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.
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.