In the financial world, the term ‘distribution’ often describes the payment of assets from individual securities or funds to an investor. One of the more common examples of distributions happens with retirement accounts, which payout to their account holders when they attain a certain age. In the broader context, a distribution can come from several financial products, with the payment typically channelled directly to the beneficiary.
Investments held within mutual funds may earn dividends or generate capital gains throughout a year, with the earnings expected to be distributed to shareholders regularly. With mutual funds, accrued income and net capital gains must be distributed, at least, annually. These distributions can be paid out to beneficiaries or reinvested into the fund.
Mutual funds make four main types of distributions:
- Capital Gains: Capital gains are the income gained from the sale of securities held by the mutual fund. For example, if a fund has stock it bought for $70 and later sells for $140, the capital gains from the sale are $70. This amount can potentially be distributed to shareholders.
- Dividends: Dividends are the income gained from owning stock and are typically accrued by the fund before distribution on a regular basis (monthly or quarterly). It’s important to note that with the disbursement of dividends, the fund’s share price reduces by the per-share distribution to the shareholders since this comes from the fund’s assets.
- Interest: Interest is earned from having fixed income securities such as certificates of deposit (CDs) and bonds. Like dividends, interest earnings are accrued over a period and distributed to shareholders. Mutual funds tend to treat dividends and interest in the same way, so that a dividend distribution will also incorporate interest earnings.
- Return of Capital: This income comes about when a fund returns a portion of an investor’s original investment, which frequently happens with master limited partnerships (MLPs) and real estate investment trusts (REITs) investments. The capital return is a possibility when the fund is unable to make enough income from its investments, therefore hampering its ability to make payments. The fund may tap into the investors’ original investment to make up for the shortfall.
Income earned from investment trusts is typically distributed on a monthly or quarterly basis, mimicking dividend distributions. With a retirement account, distribution can happen before an individual reaches a certain age or during or after they reach a certain age.
Kevin Neal, a former independent financial advisor (IFA), is a financial professional who appreciates the value of fund distributions. As part of his work with Blue Fin Capital, he has been involved in the distribution of property and alternative asset classes to investors.
Various essential issues affect a fund’s distribution to its investors or shareholders:
- Expenses: Funds will usually cater to their expenses, such as operating costs and management fees, from the income earned. Whatever is left after this is distributed to shareholders.
- Taxes: The income distributed to shareholders is taxed at their level, rather than at the fund level. Investors are required to pay taxes on their distributions, which are levied at personal tax rates. Additionally, the character of the income (dividend, interest, capital gains) is preserved for taxation purposes as rates may vary according to the type of income. Many shareholders choose to reinvest their distributions to increase their shares of the fund.
- Buying Strategy: A common mistake when investing in mutual funds is purchasing fund shares right before the distribution of capital gains or dividends is made. An investor who purchases the dividend becomes responsible for paying the current tax for the distribution, an amount that can get hefty if an investor is planning for a large investment. Checking the fund’s distribution schedule is essential before buying into it to avoid such a scenario.