Understanding Mutual Fund Income: 4 Key Earning Methods

The structure of your mutual fund will determine how you earn income when your investments are profitable. You have several options to choose from, and each will carry implications for taxes and long-term earnings. Consider high yield funds, capital gains funds, equity funds and other structures prior to deciding on which mutual fund to  buy into.

1. High Yield and Dividend Payments

High yield mutual funds have the goal of providing a constant flow of income to investors through dividend payments. At the end of a quarter, the increase of value of the shares in the fund is paid out to the investor, minus any trading expenses. This means the value held in the fund remains constant. The investor will pay taxes on the dividends in the year they are received. High yield funds are beneficial during expensive periods of life when additional income is required, such as child rearing years or in retirement. They are not wise investments if you are looking to save toward a future expense. You are additionally excluded from receiving dividend payments on any fund held in a retirement account.

2. Capital Gains

A capital gain distribution from your mutual fund is relatively similar in structure to an ordinary dividend. The difference is that the payments tend to come less frequently, and they are taxed according to a different rate. With a capital gains distribution from a mutual fund, all gains, even those earned on shares held for less than a year, are treated as long-term capital gains. This is favorable because it places the gains in a much lower tax bracket. Capital gains funds are best for investors who have a high initial value for their portfolio and would like to reduce taxes.

3. Equity Funds

Equity funds have a different goal all together than traditional dividend funds. These funds make no regular payments to investors. Instead, when a portfolio gains value, the value is translated into an increase in the amount of shares allocated to that investor. Therefore, the investment is constantly being reinvested into the fund. The result is a much higher appreciation of equity, but no on-going returns. The investor will treat these earnings like long-term capital gains, deferring payments until the shares are sold. This is a good choice for an individual looking for a long-term, net worth investment.

4. Net Asset Value Appreciation

Net Asset Value (NAV) is calculated by dividing the total value of a fund by the number of its outstanding shares. All mutual funds hope for some appreciation in Net Asset Value that would ultimately benefit each investor. Regardless of which type of payment cycle your fund operates on, if the fund increases its NAV, you will benefit through a capital gains appreciation. You can sell the shares you own for a higher value than you purchased them. This would result in a capital gains tax. An increase in NAV, on any type of fund, is an increase in your long-term net worth.