Income fund basics
What is an income fund?
Types of income funds
Fixed income, equity, or a bit of both? There are many types of income funds to choose from.
When most people think of income, they first think of their salaries. But that’s only half the story. Income is also defined as money generated through the investment of capital.
Income funds typically prioritize income generation over capital appreciation. They invest in income-producing securities such as money market securities, bonds, preferred shares, dividend-paying equities, income trusts, and more.
Like many mutual funds, income funds are structured as “flow through” entities for income tax purposes. After operating costs (and losses carried forward) are deducted, excess income is deemed to be “paid or payable” under the terms of the Declaration of Trust. This excess income is “flowed through” to investors as either a cash distribution or reinvestment in additional units of the fund. These distributions are treated as taxable in the hands of the fund’s investors.
Features of income funds
- Cash flow. Excess income is distributed to unitholders, and the distributions can be used for day-to-day expenses.
- Compounding. Investors have the option to reinvest distributions in additional units of the fund. Over time, this can mean compounding of increased distributions and the ability to buy even more units of the fund.
- Growth potential. Income funds that focus on dividend-paying equities offer the potential for capital appreciation as well as income. Bond funds also offer growth potential, especially during times of falling interest rates. When interest rates fall bond prices tend to rise.
Note the payment of distributions is generally not guaranteed and may fluctuate.
One potential risk to be aware of, particularly with bond funds, is interest rate risk. As interest rates rise, bond prices tend to fall. Other types of risk include credit risk and inflation risk. It’s important to always read a fund’s simplified prospectus to understand these potential risks before investing.
Collecting the cash
Investors can choose to receive their distributions in a number of different ways depending on their income needs.
Keep in mind that if a fund does not generate sufficient excess income to meet its distribution target, a portion of the distribution will be comprised of return of capital, which means your initial investment is reduced. It’s important to be comfortable with a fund’s ability to generate income as well as its distribution policy. If your regular withdrawals are greater than the growth in your account, you could exhaust your original investment.
It’s also important to recognize the tax implications associated with various types of income. Interest, dividends, capital gains and foreign income are taxed in different ways, and you may need to consult a tax expert.