Most investors choose to reinvest mutual fund capital gains and dividends. Funds must distribute, by law, any capital gains to investors, however, it is up to you if you want to receive these distributions or reinvest them. Reinvestment provides several benefits, but there may be circumstances when it is better to take distributions in cash.
Some advantages of reinvesting mutual funds dividends that you may find attractive include the option you have for setting the reinvesting on auto-pilot, the perk of not having to pay fees to reinvest and the benefit that compounding interest offers to increase your investment.
Exploring Mutual Fund Distributions
Mutual funds are required by law to pay out portfolio earnings to investors. Interest and dividends earned on a fund's portfolio become dividend payments to fund investors. If portfolio holdings are sold for a profit, the net profits become an annual capital gains distribution.
All distributions – both dividends and capital gains – are reported to you on a Form 1099 and must be included on your annual tax return. The tax-reporting requirements are the same if you take distributions in cash or have them reinvested. Dividends from municipal bond mutual funds are tax-exempt but still must be included in the appropriate space on your tax return.
Reinvesting Capital Gains
Because capital-gains distributions represent earnings on the value of securities held by a mutual fund, these distributions are almost always reinvested. If they are not, the value of a mutual fund account will not reflect the actual investment returns of the securities. When a capital-gains distribution is paid, the fund share price drops by the amount of the distribution. Reinvesting capital gains maintains a fund account value, rather than having the value decline by the amount of the distribution.
Benefits of Reinvestment
The option to reinvest dividends automatically is a benefit of mutual fund investing. Mutual funds are one of the few types of investments where earnings can be reinvested to compound and grow. Dividends and capital gains are reinvested at no cost, which is especially beneficial for load funds, which have a sales charge to purchase shares.
If a fund pays regular monthly or quarterly dividends, reinvestment allows an investor to buy shares as the share price swings both high and low, taking advantage of those periods when the markets are down.
Reasons to Take Cash
Investors who take mutual fund dividends as cash instead of reinvesting usually do so to use the distributions as income to pay living expenses. If someone is living off her investments, fund dividends can provide a regular stream of income. An investor might also want to take dividends in cash to use the money to buy other types of investments.
Reinvesting dividends also complicates the calculation and filing of taxes if mutual fund shares are sold. However, mutual fund companies provide cost-basis analysis to investors who sell shares. Reinvested dividends raise the investor's cost basis, which lowers any capital gains taxes.
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.