What mutual funds pay the best dividends?

QUESTION: What mutual funds pay the best dividends?

-- K. T.

ANSWER: If you're looking for a diversified fund that's full of dividend-paying stocks, you've got lots to choose from. Generally speaking, funds loaded with mature companies that pay out healthy dividends typically have the word "income" in their title, such as the Vanguard Equity-Income (VEIPX) and USAA Income Stock (USISX), to name a couple.

Nevertheless, finding the best fund in this genre is tough, since it isn't a category recognized by fund-tracker Morningstar. This means you need to weed through this group on your own — or find a professional to do it for you.

And you're in luck, since we screened the Lipper databases to come up with a quick list of the best performers. We looked for no-load U.S. diversified equity funds with the best three-year total returns, yields that beat the S&P 500 (which currently yields 1.71%) and minimum investments of $5,000 or below. Keep in mind that yield isn't the only thing you need to consider. Instead, you should look at the total return, which combines yield and capital appreciation, advises Paul Herbert, an analyst at Morningstar.

A mutual fund with a healthy yield can offer you some protection in a down or flat market. That's because even if the stocks held in the fund are losing value, their dividends provide some cushion. Over the past three years annualized, for example, the average equity-income fund is down 5.65% while the average U.S. diversified equity fund is down 8.04%, according to Lipper.

That said, funds that load up on dividend-paying stocks are generally on the conservative side, which means you shouldn't expect them to soar during any big equity rallies. Of the group, the raciest tend to be the "growth-and-income" funds, since these funds hold growth stocks. "Growth-and-income is equity income on dividend steroids," says Jeff Tjornehoj, an analyst at Lipper. Your standard equity-income fund, on the other hand, is likely to be a value fund.

Keep in mind, when searching for yield (which can come in the form of dividends or income payments), many funds outside the equity-income category could suit your needs. If your main priority is income, try going with a bond fund (in which your income will come from interest payments, not dividends), or a hybrid fund (a fund that will hold stocks and bonds). And if you're willing to consider a sector fund (which runs the risk of being considerably more volatile than a diversified equity fund) real-estate funds tend to have very generous yields, as do many utilities funds.

Finally, you should be aware that funds that hold dividend-paying stocks are anything but tax efficient. That's because dividends (as well as the interest payments offered by bonds) are taxed as ordinary income on an annual basis — even if you choose to reinvest them. Assuming you don't need the income immediately, you might want to hold this type of fund in a tax-deferred account like an IRA to eliminate your tax hit, says Robert Tull, a certified financial planner in Norfolk, Va.