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Mutual Fund Taxation

Unfortunately, mutual funds are not exempt from taxes. Nevertheless, they enjoy some tax benefits, which you will learn in the lines to come.

Types of Taxable Events

Every fund owns certain number of stocks and bonds on which interest and dividends are paid. Moreover, the fund holds securities that when sold lead to capital gains or losses in accordance with the price it can get for them. As a result, we can extract the following taxable events:

  • Dividends receipt
  • Interest receipt
  • Capital gains or capital losses realization

Mutual Fund Taxation Factors

There are two major factors that influence the taxation of a mutual fund and have an impact on the investment of an investor:

  1. During the calendar year, the investor should receive and be taxed on not less than 95% of the income and capital gains of the fund.
  2. The tax entities observe each purchase and sale that is executed by the investor as a distinct transaction on which taxes should be levied.

Mutual Fund Taxation Procedure

Mutual funds are required by law to pay distributions to their shareholders whenever dividends or interest is paid on their investment portfolios.

In order to better understand how a mutual fund operates its capital gains and income, consider the following example. Fund X is a balanced one that includes both stocks and bonds in its portfolio and has a net asset value (NAV) of $15 on March 1st. At the end of the month the fund enjoys interest on one of its bond issues. As a result a new NAV should be calculated due to the change of the assets that has occurred after the addition of the interest. It is calculated by adding to the assets the interest and then dividing the result by the number of the shares outstanding. If you assume that the income increases each share by 25 cents, then the new NAV (after the increase) will be $15.25. In the following month the NAV is again increased due to a dividend on a stock, which added another 10 cents to the NAV. Therefore the new NAV is $15.35. If we assume that Fund X four times each year pays all income as a dividend, then on May 31st the amount of the dividend it should distribute is 35 cents on a share.

As a result of these processes, the investors in mutual fund X receive distributions of 35 cents that represent dividend income that should be taxed. After the fund pays the distributions its NAV drops by this amount.

Automatic Dividend Reinvestment

From the previous example it can be seem that the whole process is not so difficult to understand. Bu the situation is complicated whenever the investors decide to reinvest the money back in the fund. As a result the dividend doesn't go out of the fund.

For those investors that have preferred their dividends to be automatically reinvested, the value of their account remains unchanged. Despite the fact that the dividend income was left in the fund, the investor in this case is still subject to taxation. This is so since the investor has more shares and the price of the shares have decreased.

In order to better understand why this happens, think of this as an actual, physical distribution in which the fund distributes the money through a mailing check. As a result the price per share will fall. This is caused because of the decreased assets and the unchanged number of shares. Nevertheless, since the shareholder has decided on a reinvestment, he will return back the check to the mutual fund and get shares in turn. Several outcomes arise:

  1. Investor owns more shares
  2. The share price is lower
  3. The total of account remains the same.

The total of the investor's dollar account remains the same as before the dividend because the latter was part of the value of the account even before the distributions were executed.

A final point should be made. Even though the income has remained in the mutual fund, the investor is liable to taxes on the acquired income.

Taxes Due to Investor's Activity

If we refer back to the previous example, very new purchase of shares was preceded by a sale. Since the investor experiences income movement and gains in the mutual fund, the IRS should be paid taxes on these movements.

Investors will pay taxes after the mutual fund distributes the income dividends. But when some shares are sold, individual investors will not receive any gains. Another factor that should also be considered is the ups and downs in the price of shares. As a result, calculations of the fluctuations between prices of the purchase and the sales should be made.

Since prices may vary from purchase to purchase, calculations on each of them should be made separately. What complicates the situation further is the possibility of having a group of shares bought at different prices. Additionally, the mutual fund may have made many transactions during a long period of time due to the frequently paid and reinvested distributions.

In order to avoid confusing you with too many details, we will stop our discussion here. Don't forget that your accountant is always ready to execute the complicated tax calculations for you. S/he is there to serve you, so take advantage of his/her services. Keep the necessary documentation to follow your transactions, such as statements from mutual fund investments. Don't be reluctant to reinvest your dividends in the mutual fund, just because of the additional tax calculations. It is worth it.

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