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Mutual funds are popular vehicles that pool together money collected from investors. This capital is then invested in securities and assets such as stocks, bonds, cash, and money market vehicles based on the fund’s profile. It might be a small-cap fund, an international fund, or a government bond fund. Investors earn income on their investments in return.
But do these vehicles pay interest or dividends? Many do. They also offer one of the easiest ways for investors to reap the benefits of compound interest.
Key Takeaways
- Compound interest is calculated on the principal amount plus any additional deposits and interest.
- Mutual funds offer one of the easiest ways for investors to reap the benefits of compound interest.
- The more money you invest and the longer it sits, the more compound interest you’ll earn.
- Reinvesting dividends and distributions increases your chances of earning more compound interest.
Mutual Fund Returns
Mutual funds are attractive investments for investors who want to diversify their portfolios. They purchase shares in a mutual fund or funds that fit their financial goals, risk tolerance, and lifestyle. The money collected is then used by portfolio managers to invest in other assets, giving investors exposure to a range of different securities.
One share of a large-cap fund gives investors a small degree of ownership in a variety of companies. Actively managed funds are monitored regularly with the fund manager reallocating assets so the fund meets its objectives.
Mutual funds pay returns to their investors in several ways. You can earn money from dividends of the securities that make up the fund holdings. The fund company normally pays income in the form of distributions. You can take these in cash or reinvest them.
Most funds also pass on capital gains to investors in a distribution. These gains stem from the sale of securities that increase in price. You can also earn a return from a mutual fund by selling your shares for a profit. You’ll realize a profit if prices for holdings rise but aren’t sold by the manager.
Compound Interest Adds up Fast
So how does compound interest factor into mutual funds? It’s paid on the accrued interest you earn. It’s calculated on the principal amount plus any additional deposits and interest. You can think of it as interest that’s paid on interest. Compound interest allows your balance to grow faster than simple interest which only takes the principal amount into account.
It’s easy to increase your compound interest as a mutual fund investor. The more money you invest and the longer it sits, the more it grows. Choosing to reinvest your fund’s dividends also increases your chances of earning more compound interest because you purchase more shares of the fund when you put the distributions back into it.
More compound interest accumulates over time and the cycle of purchasing more shares will continue to help the fund and your initial investment in it grow faster in value.
Katie Kerpel {Copyright} Investopedia, 2019.
Important
Reinvest your mutual fund distributions rather than taking them in cash if you want to earn more compound interest.
Use This in Real Life
Let’s say you open a mutual fund with an initial investment of $5,000. You then make ongoing annual additions of $2,400. The value of the fund would eventually be $798,500 with an average 12% annual return over 30 years.
The compound interest is the difference between the cash you contributed and the actual future value of your investment. Your compound interest comes to $721,500 of the future balance by contributing $77,000 or a cumulative contribution of just $200 per month over 30 years. It could be a very beneficial way to tuck away $200 every 30 days or so.
Are Mutual Fund Distributions Taxable?
Yes. Distributions are taxable if you hold mutual fund shares in a taxable account whether they’re paid out in cash or reinvested in additional shares. They’ll be reported annually on IRS Form 1099-DIV.
How Can I Avoid Paying Taxes on Mutual Fund Distributions?
Neither capital gains nor distributions are subject to income tax if you hold a mutual fund in a Roth IRA. Distributions and gains are tax-deferred in a traditional IRA or 401(k) plan.
What Is Simple Interest?
Compound interest pays returns on both the amount invested plus all previous returns. Simple interest only pays out on the invested amount each period. Compounding allows investments to grow much more quickly over time than simple interest as a result.
The Bottom Line
Compound interest is one of the simplest and most useful concepts in finance and you don’t have to be rich or a trading whiz for it to work in your favor. You merely have to understand the time value of money and start investing as soon as possible.
The principle works the same whether you invest $20 or $20 million. The mutual fund’s value grows at an increasing rate by adding the interest earned back into the original capital investment.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.
