Mutual Fund Distributions and Tax Implications
By law mutual funds are required to make distributions to its shareholders. These distributions carry their taxation implications. Distributions can be in the form of dividends, interest and capital gains.
As mentioned above, mutual funds distribute the obtained net realized gains to the investors in the fund. There are two types of capital gains - realized and unrealized. The first is obtained when the fund sells securities, whereas under the latter the securities are still held by the mutual fund. The distributions that the mutual fund makes are reflected in the price of the shares in addition to the tax liabilities you are subject to as an investor in the particular mutual fund.
Income Dividends
Mutual funds experience income dividends. They consist of interest, dividends or short-term capital gains. These represent the earning of the mutual fund from the securities that are included in its portfolio after the expenses that the fund has incurred are deducted.
Capital Gains Distributions
Capital gains distributions are those proceeds coming from the sale of portfolio securities and are usually distributed every year by the mutual fund to its shareholders. These capital gains are distributed after the deduction of losses that the funds have incurred. Distributions are reflected in the price of each share (the NAV) in the sense of its decrease. Capital gains can be used for the purpose of investing them back in the mutual fund and increasing the number of shares you possess and eventually the profits you make.
As mentioned above, distributions result in a decrease in the amount of the NAV (Net Asset Value). The amount of the decrease is equal to the amount of the distributions made. Some investors prefer not to reinvest their distributions and retrieve them in cash. In such a case they should keep in mind that distributions are still a component of the total return of the investment.
You should become familiar with the date when your mutual fund makes distributions. Even though the exact distribution day may not be announced well in advance you should keep in mind that most mutual funds execute them before the end of the year. As a result you should avoid making investments before the end of the year or at least contact the target mutual fund company to inform yourself on the effect of distributions on your potential investment. Since large distributions can have a negative effect on your future investment, contacting the mutual fund is highly recommended.
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