All mutual funds are required to make periodic distributions of their capital gains and income in order to avoid paying taxes. Depending on how well you understand and plan ahead of time, this can be a blessing or a curse.
All mutual funds are required to make periodic distributions of their capital gains and income in order to avoid paying taxes. Capital gains distributions represent gains realized from the sale of securities that a fund has held for more than one year, i.e., long-term capital gains. These distributions are taxable as capital gains at a maximum rate of either 28% or 20%. Unrealized gains, or price appreciation of securities that a fund still owns, are reflected in a fund’s daily net asset value, Net Asset Value (NAV) and is not part of the distribution process.
Income distributions are taxable as ordinary income, except for non-taxable distributions attributable to tax-exempt securities such as municipal bonds. The NAV of a fund is reduced by the amount of the capital gains or income distribution at the time of the distribution.
A fund avoids paying state and federal taxes on its capital gains and income by distributing its gains and income to shareholders within the 12 months following its fiscal year-end. Within the same time frame, a fund must distribute qualified net tax-exempt interest and foreign source income. A fund is also subject to a 4 percent excise tax if, during a calendar year, it fails to distribute an amount made up of at least:
Although mutual fund distributions seem innocuous enough – especially if you have instructed your mutual fund to reinvest all distributions back into the fund – there can be serious tax consequences involved with buying a fund just before the distribution date. For example, let’s say you purchased $100,000 of a mutual fund on December 3 and the next day the mutual fund made a 5 percent distribution. In that case, you would have to report the $5,000 as income and pay taxes on that $5,000 – even though you really did not make any money yet on your investment.
In another example, let’s say you purchased $100,000 of a mutual fund in March and throughout the year the fund’s NAV declined 10%. Nonetheless, the fund pays a distribution of 5% in December because the fund manager sold some long-term securities at a gain during the year – but not enough of a gain to off-set other portions of the fund portfolio’s decline. In this case you would have to report the $4,500 distribution as a capital gain distribution – even though your investment actually declined by $10,000.
As a result of these unintended consequences, the MutualFundAlliance.com highly recommends that before you purchase a mutual fund you determine when the fund is planning on paying its distributions. Most fund companies make these distributions within weeks of the end of their fiscal year. For example, throughout the month of December you will notice nearly every one of Fidelity’s funds paying a distribution.
Online Resources: Fund Distribution Calendars
· Fidelity Funds Network
· T Rowe Price