Why it matters how income is distributed

There are many factors to consider when buying an investment fund. Hours of research might be devoted to selecting asset classes, geographies, sectors and much more besides. One important aspect to consider is how a fund treats income distributions. On the surface, this might seem to be a relatively straightforward area, but here we will explore a number of subtleties that are often overlooked.

Income vs accumulation units

Typically, there are two categories of investment fund units: income and accumulation. The assets held within a fund will usually generate income from either dividends or interest. Income units will distribute this to investors in the form of regular (monthly, quarterly or annual) cash payments. In contrast, accumulation units will reinvest any income into additional units of the fund.

The effect of the two different methods can be seen in the following chart, which shows a comparison of how an initial investment of £20,000 grows over time, for the accumulation and income units of the same fund. A 6% growth rate and 4% income yield are assumed.

For illustrative purposes; AJ Bell Investments

At the end of a 20-year period, the initial investment in accumulation units has grown to £134,600. The income units, however, have grown to £64,100 – with a total income paid out to an investor over the period of £29,400.

The choice of income versus accumulation units depends on an investor’s goals. Income units offer regular cash payments and could, for example, be used to supplement pension income in retirement, but accumulation units offer the benefit of long-term compounding. Importantly, the two types of unit result in different tax consequences for investors.

Cash paid to investors (outside a tax-efficient wrapper such as an ISA or SIPP) from income units is subject to Income Tax at an investor’s marginal tax rate. When selling units, if the fund value has grown, an investor may be subject to Capital Gains Tax (CGT).

Despite the income being reinvested rather than paid away, distributions from accumulation funds are still subject to Income Tax at the investor’s marginal tax rate; this is known as a ‘notional distribution’. There may also be a CGT liability to consider when selling accumulation units. The slight nuance here is that, because the accumulation fund reinvests income, each distribution is also considered to be a purchase from a CGT perspective. This will increase an investor’s base cost and should be factored into CGT calculations.

Dividends vs Interest

Investment funds can hold a wide variety of underlying instruments, which in turn pay income in different ways. A fund holding shares will generally receive dividends; a fund holding bonds will usually receive interest. Some funds hold a mixture of the two types of income, and the exact mix will determine whether the fund’s overall distribution is treated as a dividend or interest payment.

A fund that holds 60% or more of its assets in interest-paying securities will, in turn, pay its distributions as interest. Otherwise, its distributions will be classed as dividends. This is an important distinction, as interest and dividends are subject to different allowances and tax rates, depending on an investor’s personal circumstances.


New investors in a fund are not entitled to any income distributions that have been accrued before they purchased their units. However, at each payment date, all investors are paid the same amount of income. To adjust for this, investment funds operate a mechanism called ‘equalisation’.

Equalisation is the amount of income that has been accrued up to the date that the units were purchased. When the fund pays a distribution to investors, it will do so in two portions:

  1. Income (accrued from the purchase date onwards). This is treated as income for tax purposes and taxed at an investor’s marginal rate.
  2. An equalisation payment (equal to the amount of income accrued from the last ex-dividend date until the date of purchase). This is treated as a return of capital rather than income; the equalisation amount is deducted from the investor’s base cost for CGT calculations.

Equalisation will be different for individual investors, depending on when they purchased their units. Income received by a fund is incorporated into its price, steadily increasing until the ex-dividend date. At this point, the price decreases by the amount of the distribution, and the income is then paid to investors on pay date.

The following chart shows a simplified version of what happens to a fund’s price between two ex-dividend dates (ignoring market movements and concentrating on distribution values only).

For illustrative purposes; AJ Bell Investments

An investor buying units at the purchase date indicated in the chart is not entitled to any of the income before this point. This amount will therefore be paid to them as equalisation; any income earned after the purchase date will be paid as income and taxed accordingly.

Fund reporting status

Many investment funds, particularly Exchange-Traded Funds, are domiciled outside the UK: popular hotspots are Ireland and Luxembourg. So-called ‘offshore’ funds bring with them some additional considerations. Funds can choose to become ‘reporting funds’ for UK taxation purposes, which ultimately affects how investors are taxed. Firstly, disposals are charged differently, as shown in the following diagram:

For illustrative purposes; AJ Bell Investments

Secondly, there are also some differences in the treatment of income distributions. UK-domiciled funds are generally obliged to distribute all of the income accrued within the financial year, but this requirement does not necessarily apply to offshore funds.

In order to qualify for UK reporting status, a fund must report its income per share to investors in two parts:

  1. the amount of income distributed to investors;
  2. the amount of income withheld in the fund, over and above the amount actually distributed to investors, which is known as ‘excess reportable income’.

Depending on their personal circumstances, investors may be subject to tax on the amount of excess reportable income that is due to them. It is therefore important to check the reporting status of any offshore funds, as this may affect your investment strategy. To help with this process, HMRC maintains a database of funds that qualify for UK reporting status: www.gov.uk/government/publications/offshore-funds-list-of-reporting-funds.


When choosing an investment funds, it is important to consider how income is treated. This might seem like a minor and technical point, but it may have a significant effect on your long-term returns when all taxes and charges are taken into account.

Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

Head of Operations, AJ Bell Investments
Mark studied Economics at Liverpool University, and has a master’s degree in International Banking & Finance from Liverpool John Moores University. Qualified to CISI Diploma level in Investment Operations, Mark came to AJ Bell with nine years’ experience in operations at a custodian and an investment management firm.