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.
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.
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.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Eligibility to invest in a Vanguard Personal Pension depends on your individual circumstances. Please be aware that pension and tax rules may change in the future and the value of investments can go down as well as up, so you might get back less than you invested. You cannot usually access your pension savings or make any withdrawals until the age of 55.
The eligibility to invest in either ISA or Junior ISA depends on individual circumstances and all tax rules may change in future.
Any tax reliefs referred to in this article are those available under current legislation, which may change, and their availability and value will depend on your individual circumstances. If you have questions relating to your specific tax situation, please contact your tax adviser.
For further information on risks please see the “Risk Factors” section of the prospectus.
Other important information
If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described in this article, please contact your financial adviser.
This article is designed for use by, and is directed only at, persons resident in the UK.
The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.
Issued by Vanguard Asset Management Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.
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