Most shares and bonds¹ 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. 

Some investors may find it confusing that funds (including exchange-traded funds, or ETFs²) come in different forms – or ‘share classes’. But it’s not that different from choosing a brand and model of a 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 amount of time 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, unless using a tax-efficient vehicle (if eligible), 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.

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; when cashing in you may be subject to capital gains tax (CGT) on the capital growth of the investment. Certain reliefs may apply, depending 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.

Vanguard General Account holders can check what information is needed to include on a UK tax return here.

This page also includes information on the UK reporting fund status and how it applies to Vanguard Irish funds. 

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.

¹ Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

² A type of investment fund that holds potentially hundreds, sometimes thousands, of individual shares or bonds. Read more here.