Investment funds are often made available in two classes: income and accumulation.1 Unlike train carriages, one class isn’t better than the other. In a contest, income vs accumulation funds always ends in a draw. That’s because they’re functionally identical, except for how they pay dividends or interest to their investors.
For brevity, I’ll only refer to dividends below. But the accumulation vs income funds rules apply equally to interest payments, too.
And everything we’ll discuss today also applies to Exchange Traded Funds (ETFs) as well as Unit Trusts and OEICs.
Note that ETFs sometimes replace the terms income and accumulation with distributing and capitalising.
The difference between income and accumulation funds
The income class of a fund pays dividends out as ever-popular cash. This goes directly to your brokerage account shortly after the fund’s distribution date. From there, you can spend them, reinvest them, or just watch the cash pile up.
The accumulation class of a fund reinvests your dividends back into itself. This buys you more of the fund, increases the value of your holding, and compounds your return.
The graphic below shows you the income vs accumulation fund effect of reinvesting a dividend, as opposed to taking the money.
The 5p dividend raises the value of a single unit of your accumulation fund to £1.05.
Note, you don’t receive additional units or shares. The reinvested dividend simply increases the value of every accumulation unit (or share) that you own.
Meanwhile, the income version of the fund hands out its dividends. In fact the value of inc units of a fund actually drops slightly when dividends are stripped from its net asset value, ready to be distributed to the lucky fund owners.
Over time, the accumulation share class price of a fund gradually climbs higher than the income class. The retained dividends increase the capital value of these acc units.
But income owners do benefit instead from regular cash paydays. These can be spent on life’s little pleasures, bills – or on other investments.
Income vs accumulation fund returns
Happily, you get exactly the same investing bang for your buck with either class of fund.
The chart below illustrates the point. It shows the 10-year returns for a FTSE All-Share index fund in both accumulation (or acc) and income (inc) varieties:
The line on the graph shows identical returns for both funds when dividends are reinvested in the income version.
In this scenario, the income fund’s performance matches its accumulation sibling over comparable timeframes. (Bar the occasional rounding error.)
However if the income fund’s dividends are spent, then its value falls behind. You can see this in the next chart:
Now we can see how badly the income fund trails (red line) when we don’t reinvest its dividends.
The blue line of the accumulation version slowly diverges from the identical starting point as those re-invested dividends boost its growth like little rockets.
And so a yawning acc vs inc fund gap opens up over time.
The acc fund demonstrates the power of compounding dividends as and when they’re earned, retained, and reinvested.
Whereas income units leave all that up to you.
Still, there’s no right or wrong choice when it comes to selecting income vs accumulation funds.
How you use your dividends depends on your financial objectives and investing preferences.
But your choice does have knock-on effects. Let’s quickly run through the key reasons why you might pick income or accumulation funds.
Accumulation vs income funds: pros and cons
Why choose acc or inc funds? Here’s why:
Spending now vs spending later
Pick income funds if you want to use dividends as spending money. That’s particularly useful for retirees who want to live off their income.
Your inc fund payouts effectively provide a rule-of-thumb spending guideline. And you limit the hassle factor of periodically selling off funds to meet your expenses.
Accumulation funds are ideal if you’re building your pot – particularly in tax shelters. Your income is automatically rolled up into a snowball of future wealth. You needn’t lift a finger.
That’s appealing given the passive investing benefits of investing on auto-pilot.
Convenience has a value all of its own in investing. Viewed through this lens, your accumulation vs income fund choice is the one that best fits your lifestyle.
Controlling investment costs
If you need to sell units or shares to meet everyday expenses, then regular income fund cash distributions can reduce costs.
When you withdraw dividends from your account, you avoid paying dealing fees compared to selling down your investments.
Some people also like to use their spare dividends to pay platform fees.
Contrarily, if you plan to reinvest your dividends then acc funds enable you to avoid:
The bid-offer spread
Your money is also put to work in the market at the earliest possible moment. That’s liable to be positive for your returns in the long-term.
Obviously you can reinvest dividends manually, too. But inevitably there’s a lag.
Fund managers must pay your broker the dividend. Your brokers must process the payment.
And then real-life sometimes gets in the way before you can do anything with the cash lying dormant in your account.
Many inc fund investors like the feeling of watching dividends roll in as live cash-money in their account.
There’s no doubt the ‘Ch-ching!’ morale boost is real. It can help you stay motivated during a long investing journey towards a faraway objective like FIRE.
The countervailing advantage of accumulation funds is that automatically invested dividends juice your returns without any danger of you self-sabotaging.
You can’t, for example, divert the cash into a wildly overvalued investment because you’ve been swept along by the madness of crowds.
And you won’t fail to reinvest into an asset on sale just because it’s taken a pounding lately.
The best habits are the ones that don’t cost willpower.
Acc vs inc fund taxation
When it comes to paying tax the critical point is that there’s essentially no difference between income and accumulation funds.
Your dividend tax, income tax, and capital gains tax liabilities are the same.
The main issue is you need to keep good records if you hold accumulation funds outside of tax shelters.
Our post covering tax on reinvested dividends in accumulation funds explains the extra step you need to take to protect yourself from being overtaxed.
If you don’t take that step, you could be unfairly taxed twice on the interaction between capital gains and reinvested dividends.
Your tax certificates and/or dividend statements from your broker should provide you with the paperwork you need to fill out your self-assessment form.
The tax certificate tots up the dividends you receive from your accumulation funds in a given tax year.
Hassle your broker if you’re not receiving this certificate after the first tax year you held your funds.
Note: you won’t get, nor need, a tax certificate if your funds are held within an ISA or SIPP. Hurrah!
Some people investing outside of tax shelters find it easier just to hold income funds.
Others – incorrectly – believe that receiving inc fund dividends will save them capital gains tax that could be triggered if they sell acc fund units to meet expenses.
But this is not the case. Accumulation fund dividends do not count towards capital gains.
Therefore you can sell acc units or shares equal to the dividends you receive without incurring a capital gain.
Does switching from accumulation to income funds trigger capital gains tax?
Switching between accumulation and income share classes within the same fund may not trigger capital gains tax – but it depends on how the tax rules are interpreted.
Snippets from HMRC tax manuals in circulation appear to suggest that such a switch doesn’t trigger a capital gains tax event.
But much depends on gnomic HMRC guidance that’s laced with technical terms and depends on opaque interactions between different pieces of tax legislation.
The tax manuals are also silent on what happens if you trade between an accumulating and distributing ETF.
The bottom line: get expert tax advice beforehand if you’re concerned about the capital gains tax consequences of a switch.
Again, capital gains are not an issue if your accumulation or income funds (or ETFs) are snugly secured in your tax shelters.
The difference between income and accumulation fund names
How can you spot an accumulating fund or ETF? The clue is usually in the name. Look out for these abbreviations:
C is for capitalising which is another term for accumulating.
Income funds or ETFs may also be termed distributing and tip you the wink like this:
Read more on Monevator about decoding fund names. You can also learn more about accumulation funds – including how to uncover their dividend history!
Take it steady,
Funds with ‘inc’ in the title indicate income units. Meanwhile ‘acc’ indicates accumulation.
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A quick confusion-buster on the difference between income units and accumulation units and which you should use.
The post Income vs accumulation funds – what’s the difference? appeared first on Monevator.