When selecting a mutual fund, an investor is faced with a number of big choices. One of the more confusing decisions is choosing between a fund with a growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which fund is best for you will depend on your individual needs and circumstances as an investor.
Key learning points
- Mutual fund investors who do not wish to withdraw their dividend payments can choose from a growth option or a dividend reinvestment option.
- With a growth option, the investor lets the fund company invest the dividend payments in more securities and eventually grow their money.
- Dividend reinvestments allow fund managers to use dividend payments to buy more shares in the fund on behalf of the investor.
- Individual retirement account (IRA) holders cannot withdraw pre-retirement dividend payments without penalties and must instead choose to reinvest.
Investment funds with a growth option
The growth option on a mutual fund means that an investor in the fund will not receive any dividends that can be paid out by the shares in the mutual fund. Some stocks regularly pay dividends, but by selecting a growth option, the mutual fund holder allows the fund company to reinvest the money it would otherwise pay out to the investor in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund.
The growth option is not suitable for the investor who wants to receive regular cash payouts from their investments. However, it is a way to maximize the fund’s NAV and, when selling the mutual funds, realize a higher capital gain on the same number of shares they originally purchased. This is because any dividends that would have been paid out by the fund company have been used to invest in more stocks and grow clients’ money. In this case, the investor does not receive more shares, but his share in the fund increases in value.
Mutual funds with a dividend reinvestment option
The option to reinvest dividends is very different. Dividends that would otherwise be paid to investors in the fund are used to buy more shares in the fund. Again, no cash is paid to the investor when dividends are paid on the shares in the fund. Instead, cash is automatically used by the fund’s managers to buy more fund units on behalf of investors and transfer them to individual investors’ accounts.
This method increases the number of shares owned over time and typically results in a faster appreciation of the account than if dividends were not reinvested. Many investment companies offer this service to shareholders for free.
Investors realize a capital gain on the sale of their holdings in the fund, which in the event of the dividend reinvestment option is likely to be more fund units than they started with.
Whether you choose a mutual fund with a dividend reinvestment option or a growth option, you are choosing to forgo the regular dividend payments in favor of the fund to use that money to grow your holdings.
Selecting a Dividend Payment Option
In most cases, it is up to the shareholders to reinvest or pay out dividends. An exception to this would be in the case of individual retirement accounts (IRAs). Dividends on IRA accounts must be reinvested by shareholders who have not yet reached retirement age so as not to incur early withdrawal penalties from the Internal Revenue Service (IRS).
In a dividend payout scenario, dividend payments from the mutual fund are paid directly to the shareholder. If the shareholder chooses this option, dividends are usually deposited directly into a cash account, electronically transferred to a bank account, or sent by check. As with the dividend reinvestment option, in most cases shareholders do not have to charge a fee for paying their dividend in cash.
The choice to reinvest or distribute dividends does not affect the tax consequences of those dividends. From a tax point of view, dividend payments are treated identically in both situations.
A shareholder can choose to skip both the growth and dividend reinvestment options and instead have the dividends paid out immediately; in this scenario, the money is paid directly to the investor.
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It comes down to
No mutual fund is perfect for every investor; that’s why there are so many with so many different options. When investing in a mutual fund, it is best to research its specifics to avoid investing in a fund that does not meet your unique growth or cash payout requirements.