Most shares and bonds typically pay their investors an income. In the case of bonds, it’s usually a fixed rate of interest, which is why bonds are often classed as ‘fixed income’.

Shares too can pay an income in the form of dividends. However, companies aren’t obliged to pay it and sometimes don’t, so it’s less dependable income. Find out more on the difference between shares and bonds.

Some investors may find it confusing that funds (including exchange-traded funds, or ETFs) come in different forms – or ‘share classes’. But it’s not that different from choosing a brand and model of car and then deciding whether you want an estate or saloon version. 

There are two principal types of share class: ‘income’ (also known as ‘distributing’) and ‘accumulation’; and they both practically do ‘what they say on the tin’. Income share classes pay income out to their investors, while accumulation share classes let that income build up (or accumulate) in the fund.

In the simplest terms, income shares are better suited to investors looking for an income while accumulation shares are more for investors seeking to grow their capital.

What happens to the income?

Funds are constantly processing streams of income on behalf of their investors.

In an accumulation share class, the income is simply re-invested by the fund in more shares and/or bonds, to ensure it tracks the index as closely as possible.

This also happens with income share classes, but the difference is that some of the portfolio’s holdings will then be sold in order to fund distributions (or income payments) to the investor, equal to the amount received by the fund.

The time gap from when a fund receives income and when it has to pay out distributions to fund holders might be days, weeks or even months, but markets will move in interim. By reinvesting the income until it is time to pay out, the fund ensures it tracks its index as closely as possible.

An important point to remember, if you rely on an income, is that the amount of income you receive may vary.

Tax perspective

From a tax perspective, returns from both income and accumulation shares incur tax. For holdings in UK funds (and non-UK funds with UK reporting fund status):

• You may incur tax on the income derived from interest or dividends; upon cashing in you may be subject to capital gains tax (CGT) on the capital growth of the investment.  Certain reliefs may apply, dependent on your personal circumstances.
  
  
• Accumulation shares, which do not pay out a regular income, nevertheless are taxed on the ‘accumulated income' at your regular income tax rate and the income needs to be disclosed on your tax return. Any capital growth is also subject to CGT.
  
  
• For both income and accumulation shares, the tax rate applied to income depends on whether the income is treated as interest income or dividend income. 

We have information on what you need for a tax return if you hold a Vanguard General Account and on UK reporting fund status and how this applies to Vanguard’s Irish funds.

If eligible, you can minimise the tax liability by investing as much as you can in tax-efficient vehicles, such as an Individual Savings Account (ISA) or a pension, which do not incur tax on either income from interest or dividends or on capital gains.

Another factor to consider, especially for ETFs that invest in overseas bonds, is whether or not to opt for currency-hedged share classes. 

The inner workings of different share classes may be complex, but the question for investors is simple. Are you looking for a regular income? Or do you wish to grow your capital? The choice is yours.