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Capital Gains Taxes

Often mutual fund investors wonder why they should pay taxes on a fund that has experienced a losing year. Distributions represent the fund's profit which was realized when selling the securities. These distributions have to be declared annually. Every shareholder of the fund is paid, usually at the end of the year, his share of the fund's gains.

Capital Gains = price you sold the securities - purchase price (cost basis)

Despite the underperformance of the fund's securities, distributions must be paid to the shareholders. What matters is that the fund has made a certain profit out of the securities and it should be distributed among the shareholders in the form of income dividends or capital gains. As a result, taxes should be paid.

Consider the following example to better grasp the concept. Imagine that you have purchased a security that cost $18 per share in 2000. At the beginning of 2005 you sold the security for only $ 28 per share, even though it was worth $36 per share. You have made a $10 profit, but this represents an overall loss for the year since you could have sold the security for a higher price. An alternative course of action may be the selling of the security for $40 per share, which represents a gain even for 2000, but this profit may be offset by losses in the other holdings of the fund. This also represents a taxable event.

Let's consider some additional situations and see when taxes are levied.

  • Capital losses

    If the fund was not able to sell above the purchasing price, then it is incurring capital losses. In such a case, the fund is not required to pay distributions, since it has not made any profits. The sustained losses will be applied to the capital gains that will be obtained in the future.

  • Dividends reinvestment

    If you have signed up for an automatic reinvestment of the acquired dividends, you should pay again taxes since such reinvestments by law are considered cash payments.

  • Purchase of a fund a day before distribution

    Always try not to buy a fund just before it is about to pay distributions to its shareholders, since it does not matter for how long you are an owner of the shares. You have to pay taxes! The NAV (net asset value) is reduced due to distribution, but this does not allow you to obtain investment income on the amount on which taxes are levied.

  • Mutual funds in IRA or 401 (k) plan

    Since taxes do not affect nontaxable accounts, you are safe until you begin drawing money out of these accounts.

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