Have you ever heard someone say “it pays dividends?” Usually, you have just been given a nudge to do something now that might pay off later. In the investing world, it’s no different.

So what are dividends and how do they work?

Dividends are payments companies make to their stockholders to share their profits. Typically paid quarterly, dividends are like a reward for investing your money into a company’s venture. See? You invest with us now, and we’ll give you something—a dividend—later.

Companies usually pay out dividends in cash. But there are other types of dividends you could receive, including stock dividends and opportunities to do some dividend investing. We'll get to all that in a minute. But first, let’s take a look at how dividends work.

Dividends are paid out in a number of different ways from a stock.

• Cash dividends. They’re exactly what they sound like: cash paid out to you on your investment.
• Stock dividends. This one’s also pretty self-explanatory. Instead of cash, you’re given additional shares of stock. Now you own a little more of the company than you did before.
• DRIPs. This terrible acronym stands for dividend reinvestment programs. DRIPs let you reinvest your cash dividend back into the company’s stock—often at a discount.
• Special dividends. This kind of dividend is a wild card. A company can give out special dividends if they’re sitting on extra profits they don’t have earmarked for something else. These types of dividends are more one-offs and don’t arrive on a schedule like other dividends.
• Preferred dividends. This is another unique type of dividend. A preferred dividend is paid to owners of preferred stock. This type of stock differs from common stock in that with preferred stock, shareholders don’t have any voting rights. Preferred dividends will follow a payout schedule similar to cash or stock dividends, but they’re usually a fixed amount rather than a fluctuating number.

So what does this have to do with my Mutual Funds?

To review, most mutual funds hold stocks. That’s the backbone of our investments and where most of the pleasing returns come from. Ever opened up your account statement and seen a huge jump in the value? That’s just stocks doing what they do best. When a stock is held within a mutual fund, and that stock pays out a dividend, it pays it out to the mutual fund company (Fidelity, CI or EdgePoint).

Do Mutual Funds Pay Dividends?

Now, dividends don’t only come from single stocks. Other investments, and even some insurance companies, also pay dividends. Mutual funds that hold stock in companies that pay dividends can pass along those dividends to shareholders who have the option of getting a payout (typically once a year) or having dividends reinvested in additional shares of the fund. Within a mutual fund, dividends are not consistent year after year and it’s hard to pin your hopes on a certain dollar amount.

At this point you’re probably wondering: Why haven’t I received a dividend check from the mutual funds in my RRSP or RRIF account? This is because retirement accounts require shareholders to reinvest any distributions paid by the fund. So if you look really closely at your retirement account statement—yeah, we’re guilty of just looking at the big number at the bottom too—you’ll probably find a line item for distributions. The only option for having your distributions paid out to you, is in your Open or Non Registered Account. Distributions are automatically set to be reinvested at the account opening time, but we can change that depending on your income needs.

Bonds are another type of investment that can pay dividends. As a refresher—when you buy a bond, you’re lending money to a company or government entity. In exchange for your loan, the company or government agrees to pay you a fixed rate of interest, aka a dividend. Unlike stock dividends, bond dividends are a legal obligation, meaning the company or the government entity you loaned money to has to pay you dividends.

We don’t recommend hinging your investment strategy on bonds though. You’re better off investing your money in a mix of growth stock mutual funds.

Wait, you just said Distributions. Is that the same as Dividends?

Similar, yes, the same, no. A dividend, as we have learned, is a sharing of the profits by shareholders of a stock. That profit is paid to the shareholders and in this case, the mutual fund companies. The mutual fund companies generate income through stock holdings, and also stock trades that generate capital gains. When a mutual fund pays out profits to its unitholders, it is called Distributions and it is a mixture of stock dividends, capital gains, interest income, return of capital and foreign income.

So Why Do Mutual Funds pay out Distributions? Wouldn’t it be better to keep it all in the Mutual Fund?

Great question, and the answer is no. When stocks pay out dividends to a mutual fund company that owns shares in them or create capital gains from selling a company that they have made a profit on, they are creating taxable income for the mutual fund. Mutual funds also pay taxes when they create ordinary income……the tax man always gets their dollar. When a mutual fund pays out distributions to its unit holders, it passes some of the tax liability on to the unit holder as well.

Here is the difference between us (the unitholder) and Fidelity. We pay tax on a graduated scale when we complete our tax returns, with the average marginal tax rate in Ontario at 30%. When a mutual fund company pays tax, it does so at the highest marginal tax rate of 54%. See the difference? When a mutual fund pays tax on its earnings, it can take a big bite out of your profits. It’s better to pass it on to the unitholders at a much lower tax rate.

Dividends can be a nice cherry on the top of the sundae, but it is not the main focus of the portfolio managers when they are evaluating companies. Finding companies that will grow and be profitable over the long term is the focus of the portfolio managers. Buy Low, Sell High.