You probably agree that socking away money in a mutual fund that pays regular dividends can't hurt. Dividends give you the flexibility to take those distributions in cash or reinvest them back into more shares of the fund. As a long-term holding, it is hard to go wrong with a dividend-paying fund that follows investing goals that match your own. Picking up some shares of a dividend-paying stock fund will generally be a more conservative choice than a fund holding nondividend-paying growth stocks.
If a mutual fund earns dividends or interest from its portfolio, these earnings must be passed along to investors as fund dividends. The dividends from a bond mutual fund are your share of the interest and yield earned on the fund's portfolio of bonds. Investing in a bond fund is all about the dividend yield and stability of the share price. Stock market funds can choose whether to focus on dividend-paying stocks. The dividend yields from individual stocks a fund may own can range from nothing to double-digit yearly percentages.
Growth vs. Income
The investment objectives of a mutual fund are your first indication whether the fund will hold a lot of dividend-paying stocks or shares of companies that don't pay dividends. For example, a biotechnology fund buying shares of startup companies will not earn dividends that can be paid out to fund investors. However, a blue chip stock fund holding shares of large, name brand companies will earn dividends from most of its stocks and pay an attractive dividend. A look at a fund's list of stocks and dividend payment history will show you where it lies along the growth-versus-income spectrum.
Historical Market Returns
Dividends have provided a significant slice of the historical return from stocks. A chart from Bloomberg BusinessWeek shows that for a period from 1990 to 2010, 43 percent of the return from the S&P 500 stocks came from dividends. Stock dividends are paid even when share prices are flat or going down. This provides at least some form of return to investors during these periods in the market.
Power of Reinvesting
A big advantage of mutual funds is the ability to have dividends automatically reinvested into more shares. This can help with dollar-cost averaging, or buying shares on a regular schedule to help protect against wild swings in the price. The perks also include compound growth of your account and no sales charge on the reinvestment of dividends in a "load fund" -- a fund with a commission built into the cost. Investing in a dividend-paying fund allows you to take advantage of these benefits.
To IRA or Not
A potential issue with a dividend-paying fund in a taxable account is that you must pay taxes each year on the dividends, even if you reinvest the money. One way to avoid this is to own a dividend-paying fund in an individual retirement account. You can set up an IRA directly with a fund company or buy fund shares through an IRA at a discount brokerage firm. If you want to own several funds, it may make sense to stuff the big dividend-yield funds in your IRA and hold nondividend-paying funds in a taxable account.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.