Updated July 10, 2023
Definition of Income Funds
An income fund is a mutual fund or an exchange-traded fund (ETF) whose main objective is to provide stable income to its investors from their investments. The income fund emphasizes more on current income rather than capital gain income. They invest in bonds, securities, shares, and dividend stocks.
Explanation
Income funds are majorly debt funds, i.e., they majorly invest in instruments of debts such as debentures, government securities, corporate debt obligations, etc. The objective of such funds, irrespective of the asset class they invest in, is to generate current income for its investors and distribute them regularly amongst the investors. Such investments are usually for a long time, four or more years. It always tries to meet the objectives of investors looking for a stable return with low risk. The price of the income fund shares varies depending on the interest rate. The price of the shares increases with the decrease in the interest rate and vice versa.
Features of Income Funds
- In income funds, there is safety for the investors as there is a reduction of risk, which is a favorable factor for investors who tend to avoid risk in investments.
- The return rate is higher than the risk factor, and the investor enjoys a stable income against their investments.
- The income fund provides good liquidity as investors can liquidate the shares before the maturity date; however, they will receive a lower return on their investment.
- Investors can liquidate the shares before the maturity date in the income fund, but they will receive a lower return on their investment.
Examples of Income Funds
- Rowe Price Equity Income fund: It is one of the largest income funds which invests at least 80% in stocks with a priority on large-capitalization stocks. According to the latest studies, the T. Rowe Price Equity fund has $21.23$ billion in assets.
- Lipper Equity Income Funds Index: An income fund with an unmanaged index cannot be directly invested in. It usually finds funds seeking high current income by investing at least 65% in dividend-paying equity securities.
- Vanguard Equity Income Fund: This fund provides investors with more than the average level of current income while providing exposure to the stock market. Such funds prioritize the companies that are growing slowly and yielding higher. Therefore, it is suitable for investors looking to invest in the long term.
Taxation on Income Funds
Investors can determine the tax to be paid on the income fund by considering the type of distribution received, the duration of the investment holding, and the type of investment. Subsequently, they can calculate the taxes applicable to the income fund. The taxation on income funds can be categorized into the following three points.
- Dividends: The dividends received are taxed as ordinary income if the income funds trade in dividends more often. For example, if you receive $10,000 in dividends as payment on investment and the investor pays 24% income tax, then the investor has to pay $2400 as a tax on income funds.
- Interest: Investing in tax-free income funds will reduce the income tax liability since such interest will be exempt from income tax. Such funds invest in the bonds of government and municipality as these provide tax-free interest on investment and are stable and safe. If the funds are not tax-free, the interest income will be taxed as the taxpayer’s ordinary income.
- Capital Gains: Capital gain refers to the profit from selling a capital asset above its purchase price. The taxation of capital gains depends on the jurisdiction of the income fund. In the US, the tax treatment for short-term capital gains treats them as ordinary income, while the taxation of long-term capital gains varies based on the individual’s income level. In certain cases, the tax rate may be zero, while higher income levels may be subject to higher tax rates.
Who Should Invest in Income Funds?
Investors with moderate risk tolerance and seeking a fair and stable investment should invest in income funds. However, any investor with requisite funds can invest in them as professional managers will look after their objectives of getting regular payments with low risk. They are also favorable for newbies willing to explore mutual funds.
Advantages
- Professional Management: Some professional managers manage the investment in the income fund. Such managers are highly educated to generate a high return rate.
- Reduction in Risk: Investors in income funds experience greater safety due to the low level of risk resulting from diversifying investments across different asset classes, thereby covering potential losses with profits from other investments.
- Stable Income: There is stability in return in the income fund as such funds distribute the returns to its investors frequently, such as monthly, quarterly, and so on.
- Liquidity: The investor enjoys the advantage of liquidity in the income fund even before maturity, but the investor will get a low rate of return if liquidation is done before the maturity date.
Disadvantages
- High Charges: Professional managers in the income fund charge fees for their service, increasing the expense ratio. The investor would get a lower return on investment.
- Mismanagement: There is a possibility of mismanagement by the managers in the income fund as the managers do all the work. If the managers are not working efficiently, they can do mismanagement.
- Long-Term Investment: The investment in the income fund is usually for a long time, so if the investor is in urgent requirement of the fund, the investor can liquidate, but it will cost the investor a low rate of return.
Conclusion
An income fund is important as it attracts customers, avoids risk, and seeks a stable income. Investors looking for current income distributions can benefit largely from these funds, especially in a higher age group.
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