DIVIDENDS

Ordinary dividends are dividends or interest passed on to you from the earnings of a mutual fund's holdings. Funds pay these dividends monthly, quarterly, or semiannually.

Funds that are oriented toward paying steady income to their shareholders focus on bonds and high-dividend-paying stocks such as preferred stock and the common stock of utilities. They are less concerned with growing the net asset value of their shares. Many such funds even have the word "income" in their names.

Dividends from mutual funds are taxed as ordinary income. Municipal bond funds differ with respect to taxes: they pay dividends that are free of most federal taxes and sometimes state taxes.

When a mutual fund sells shares of its holdings at a profit, it may pass this profit on to its shareholders as a capital gains dividend. Capital gains dividends frequently occur at the end of the year in many funds. You will be taxed at the short-term or the long-term rate depending on how long the fund held the shares.

Soon after a fund makes a dividend payment, it notifies shareholders with a dividend notice. The notice spells out the dividend's dollar value per share. If there is a capital gains dividend, it will specify the short- and long-term gain components.

In addition to dividends, mutual fund shares can earn money by increasing in value. We will discuss the capital gains of mutual funds next.