"Buying the dividend" or "buying the distribution" happens when you invest in a mutual fund just before it declares dividends or capital gains distributions. Doing this in a taxable account will generate an unnecessary tax bill. Let's look at an example.
Imagine that on Monday, you buy 100 shares of the Ominously Overdiversified Mutual Fund (ticker: OOMFX) at $30 each, for a total of $3,000. Let's say that the fund had previously announced a $2 distribution for each share, to occur on Tuesday. This means it sends you $2 per share, or $200, and your $30 shares are now worth $28. (Note that 100 times $28 is $2,800, which when added to $200 yields your original $3,000 investment.) It's not exactly six of one, a half dozen of the other. That $200 distribution counts as income to you, and you'll be taxed on it.
By buying just before the distribution, you end up paying some taxes needlessly. Most stock funds declare dividends and capital gains distributions either every three or six months, or every year. It's best to find out when a fund's distribution will take place and avoid buying in right before it happens. (You can usually just call up the fund company and ask.)
This isn't an issue for money market funds, bond funds, or funds in tax-deferred accounts such as IRAs or 401(k)s.
Learn much more about the mutual fund industry in John Bogle's well-regarded book, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor. Learn more about investing in mutual funds in our Mutual Fund area, and zero in on our index fund information there.
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