Folks looking to supplement their income might turn to mutual funds that pay a dividend every month. Mutual fund dividends stem from dividend and interest income earned by the fund’s portfolio. Many such funds have “income” in their names. Mutual funds must disclose their yields and dividend calendars so investors can know up front how much to expect and how often to expect it.
Many, if not most, bond funds pay dividends monthly. These dividends stem from interest earned on a portfolio of bonds and other interest-bearing instruments. The yield of a bond fund depends on the safety and maturities of the securities held by the fund. A short-term government bond fund is a pretty safe bet, but you can also bet that returns will be punk. At the other extreme, a fund made up of high-yield corporate bonds -- known as junk bonds -- pays more interest but also introduces the risk that some of the bonds may default on interest or principal payments. The diversification of mutual fund portfolios helps keep default risk in check.
Mutual funds can provide income by investing in dividend-paying common and preferred stocks. Investors will have to search harder for stock funds that make monthly payments. The fund’s dividend yield is the amount of annual dividend income divided by the fund’s net asset value, or NAV. Certain mutual funds specialize in high-yielding preferred stocks. The dividends from mutual funds that hold U.S. stocks usually qualify for lower, long-term capital gains tax rates. An investor must hold the mutual fund for at least 61 days to take advantage of the qualified dividend tax break.
Municipal Bond Funds
Investors in higher tax brackets or living in states or cities with high income tax rates might seek out tax-free monthly income from municipal bond mutual funds. The income from these funds is free from federal income tax. Fund companies offer muni funds that specialize in bonds issued by high-tax states such as California or New York. Residents of these states can buy the appropriate muni funds and avoid state taxes on the income. Some municipal bond funds limit their holdings to insured bonds. This reduces yield but provides additional safety to investors.
Income Replacement Funds
A few mutual fund companies have introduced “income replacement” funds. These make monthly payments that are a mix of income and return of principal. The goal of these funds is to provide reliable payments each month. Investors can choose among replacement funds that have different target dates. The fund attempts to preserve enough investor principal each year so that payments continue until the target date before the principal is depleted.
Closed-end mutual funds trade like stocks. The shares represent a basket of securities owned by the mutual fund company. The share price of a closed-end fund depends on the supply and demand for the shares, not on the NAV of the portfolio. You’ll frequently find closed-end mutual funds selling at a discount to their NAVs. This can be a bonanza for income investors, because the greater the discount, the higher the yield. On the minus side, closed-end mutual funds usually have higher fees than do their open-end brethren.
- CNN Money: What’s a Bond Fund?
- Internal Revenue Service: Publication 550 -- Investment Income and Expenses
- T Rowe Price: What Are the Benefits of Tax-Free Mutual Funds?
- Oblivious Investor: Are Income Replacement Funds Better Than Annuities?
- The Wall Street Journal: The Mystery of Closed-End Fund Discounts
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