Most mutual fund companies offer a reinvestment plan that allows you to automatically roll over, or reinvest, the income you earn on your mutual fund investments. Any income that you reinvest is used to buy additional shares of the fund.
For example, if your mutual fund's net asset value is $15 a share and your fund distributes $150 to you in dividends and capital gains, a reinvestment plan would automatically buy 10 additional shares at the fund's current NAV.
Mutual funds are required to make distributions at least once a year but many distribute dividends every three months when companies typically pay dividends to their shareholders.
Reinvesting is a pleasure as long as the fund is earning a rate of return that compensates you for its investment risk. (Riskier funds, as measured by the volatility of their returns, require higher rates of return.) If you decide you want to stop using a reinvestment plan, simply ask the fund to send you a check instead. You can always deposit it in an interest-bearing account, spend it or invest it in another fund.
Mutual fund income is earned from capital gains and dividends. In either case, the IRS still requires you to report the income on your tax return even if you reinvest your earnings.
Reinvesting your mutual fund income works to your benefit the same way compounding boosts your yield on a CD or other deposit. Instead of spending the income, you're putting it to work for your future in the easiest and least-costly way.
Mutual funds generally offer reinvestment plans for no fee since they benefit by keeping your business. A reinvestment plan also helps you to accomplish dollar-cost averaging.
Dollar-cost averaging is a fundamental investing principle that says it's in your best interest to make steady contributions over time rather than seek to time your purchases. Over time, dollar-cost averaging results in a lower average purchase price. A great deal of financial research done over decades backs up the benefits of dollar-cost averaging.