Mutual funds are often designed as growth instruments in which case you only make money if you redeem your shares for profit. However, investment companies also offer funds that are specifically designed to provide you with an ongoing income stream. Income funds come in many varieties and as with most things these funds expose you to a degree of of risk. While income is typically taxable, some mutual funds even offer potentially tax-exempt income streams.
When you buy a stock you become a part owner of a publicly traded company. Your stake in the firm rises and falls in line with the performance of that company. Generally, stocks are viewed as growth instruments but stocks in some large companies can also serve as income-generating instruments. Major corporations often share profits with investors by regularly issuing dividend payments. Some dividends are fixed at a certain amount while others fluctuate over time. You can buy income-producing mutual funds that invest primarily in dividend-paying corporations. The mutual fund company collects the dividend payments and in turn passes on the cash to shareholders. Depending on the fund, you may receive dividends on a monthly, quarterly or annual basis.
Governments and corporations borrow money in the form of debt instruments known as bonds. You can buy bonds with terms ranging from a few days to 30 years. As a creditor of the bond issuer, you receive interest on the debt either throughout the bond term or as a lump sum when the bond matures. Some mutual fund companies create funds that contain thousands of bonds with varying terms and interest rates. The interest payments are collected and passed on to shareholders as monthly dividend payments. The mutual fund's board of directors sets the distribution rate, which is the percentage of the interest earnings that is passed on to investors.
Under the federal tax code, you do not have to pay federal income tax on interest payments derived from certain kinds of municipal bonds. Typically, these are general obligation bonds that are liabilities of cities and states as opposed to revenue bonds, which are municipal debts that may be tied to private projects. Additionally, you pay no state income tax on municipal bonds that were issued by government agencies in the state where you are domiciled. Generally, yields on municipal bonds are lower than on corporate bonds but depending on your tax bracket, you may come out ahead even if the interest rate appears low.
Some funds contain other types of income-producing securities such as credit default swaps. A swap works similarly to an insurance contract although insurance regulators have no oversight on these products. One party pays premiums to another party and the receiving entity promises to make a payout if a certain event occurs. For example, the agreement may require one party to make a payout if a particular market index drops. If you buy a fund that holds swaps then you get income that is derived from the premium payments the fund receives. Your income could dry up and the fund lose money if a payout ever occurs.
- Securities and Exchange Commission; Invest Wisely; An Introduction to Mutual Funds
- FINRA: Mutual Funds
- FINRA: Default and Credit Risk
- FINRA: Smart Bond Investing
- Investment Company Institute: Frequently Asked Questions About Taxation for Mutual Fund Investors
- Federal Deposit Insurance Corporation: The Use of Credit Default Swaps by U.S Fixed-Income Mutual Funds