Dividend Mutual Funds Definition, Advantages, and Tips

Financial figures and bar graphs

Roy Scott/Getty Images

You may have heard that investing in dividend mutual funds is a good idea. But are these mutual funds a good fit for you and your investment objectives? Before investing in dividend mutual funds, be sure to understand what they are and to learn the basic pros and cons of these mutual funds that pay dividends.

Dividend Mutual Funds Definition and Advantages

Dividend mutual funds are stock mutual funds that primarily invest in companies that pay dividends, which are profits that companies share with stock shareholders.

Dividends can be received as a source of income or they can be used to buy more shares of the mutual fund. Most investors who buy dividend mutual funds are usually looking for a source of income, which is to say that the investor would like steady and reliable payments from their mutual fund investment.

In most cases, because of their income-generating nature, dividend mutual funds are best-suited for retired investors. Dividend mutual funds also tend to be less aggressive (less risky) than other types of funds, such as growth stock mutual funds.

Some investors also like to use mutual funds that pay dividends in economic environments where bond mutual funds are not attractive. For example, when interest rates are low but economic conditions are generally good, bond funds can have lower yields than dividend mutual funds.

Disadvantages and Tips for Using Dividend Funds

All of the above may be considered benefits, advantages or pros of dividend mutual funds but the income-producing nature of these funds can be a disadvantage.

Investors should be cautious of using dividend mutual funds because dividends are taxed as ordinary income. For this reason, some investors may consider buying dividend mutual funds in an Individual Retirement Account (IRA) or (k), where earnings grow tax-deferred until withdrawals begin. Therefore mutual fund investors should be aware of the taxation of mutual funds before investing.

For example, if you buy and hold dividend funds in a regular brokerage account, the dividends are taxed as regular income. And if you're wanting to keep taxes to a minimum, you may not like the added tax that comes from dividends.

An easy way to invest in dividend-paying stocks with mutual funds is to use Index Funds or Exchange Traded Funds (ETFs). These mutual funds usually hold large-cap stocks that pay dividends. In the case of index funds, they often hold the stocks within an index, such as the S&P 500, that pay the highest dividends. Some dividend funds also buy and hold stocks of companies that have track records of increasing their dividends. This way, the investor has the potential to receive dividends but also increase them over time.

When researching dividend funds, you can get a good idea of the past and future dividend payouts by analyzing the fund's yield. The 30-Day SEC Yield of a mutual fund refers to a calculation that is based on the 30-day period ending on the last day of the previous month. The yield figure reflects the dividends and interest earned during the period, after the deduction of the fund's expenses.

A mutual fund's trailing 12-month yield, or TTM, refers to the percentage of income the fund portfolio returned to investors over the past 12 months.

Therefore the 30-Day SEC Yield gives you an idea of the current yield and what you might expect in the near future. The TTM yield gives you an average payout from the past, which may or may not repeat over the next 12 months.