Description. Mutual funds pass through tax liabilities as well as benefits. As a general rule, the fund shareholder has a taxable event whenever the fund does. There are three major taxable events for funds: (1) the receipt of interest; (2) the receipt of
dividends; and (3) the realization of capital gains and losses. Funds receive interest and dividends from
bonds and
stocks that they own, just as an individual would. Further, funds realize capital gains and losses when
securities are sold by the funds. Two important concepts govern fund tax effects for the investor. First, at least 95% of the income and capital gains a fund receives must be passed-through and taxed to the investor, in the calendar year that the fund earns them. Second, each purchase and sale by the investor is a separate transaction for tax purposes.
How it Works. When a fund
receives dividends or interest income from its
portfolio,
it must distribute the amounts received to its
shareholders
as a dividend of its own.
Here's how
income
and capital gains are handled by a fund, step-by-step. Let's
start with a balanced (i.e., a stock and bond)
mutual
fund. On January 1st, the fund's
net
asset value is $10.00. On January 31st, the fund receives
interest on a major bond
issue
it holds in its portfolio. The first thing that happens is
that the interest received is added to the
assets
of the fund, then divided by the number of outstanding
shares,
to determine a new net asset value. In this case, let us suppose
that the income adds 10 cents to each share. The new net asset
value is now $10.10. On February 15th, a dividend is received
from stock, and increases the value of the average share by
5 cents. Now, the net asset value is $10.15. In our example,
we could further suppose that this fund pays out all income,
as a dividend, four times a year. Therefore, on March 31st,
the fund will pay a dividend of 15 cents per share. Two things
happen. First, the investor receives a taxable dividend income
distribution
of 15 cents. Second, the fund's net asset value drops by 15
cents.
That income distribution seems simple enough, if you assume
that it is physically paid to the investors in the fund. The
fund's value drops by the 15 cents per share that it pays
out, and the investor has an equivalent amount of taxable
income. The same process holds true for investors who reinvest
their dividends, but it seems more complicated because the
money stays in the fund.
For the investor who has automatic dividend reinvestment,
his or her account maintains the same value; but the share
price has dropped, he or she has more shares, and he or she
must pay taxes on the income, even though it was left in the
fund. How can this be? The simplest way to keep track is to
think of this as an actual, physical distribution.
If it were an actual, physical distribution, the fund would
pay the money to the
shareholder,
perhaps by mailing a check. The price per share would drop,
commensurate with the distribution, because the assets in
the fund decline while the number of shares stays constant.
So far, it's just like the shareholder who takes the distribution
and spends it. But at this point, the reinvesting shareholder,
in effect, mails the dividend check back to the fund, to purchase
more shares. Now, he or she will own more shares, and the
price per share is still lower than it would have been without
the dividend payout. Finally, his or her account dollar total
has not changed from prior to the dividend, since the dividend
was part of the account value prior to distribution. Now,
let's review the situation, as stated above, and see if it
makes more sense:
"For the investor who has automatic
dividend reinvestment, his or her account maintains the
same value; but the share price has dropped, he or she has
more shares, and he or she must pay taxes on the income,
even though it was left in the fund."
One last point, and then I promise we'll get
away from this tax stuff. Up to now, we have looked only at
taxable events created by the fund's internal activities.
However, we also need to view the investor's activities, in
order to see the rest of the mutual fund tax picture.
As alluded to above, each purchase is ultimately tied to a
sale, from the investor's perspective. The IRS wants to be
paid on all income and gains that investors make in their
investments. The same holds true in mutual funds.
Ultimately, funds will distribute all income and gains in
the form of dividends, and at that point, investors will be
taxed. But, for individual investors, some gains will not
have been distributed when shares are sold. We also need a
way to take into account share price fluctuations (up or down).
Therefore, investors not only pay income taxes on dividend
distributions, but we also must calculate principal changes
between purchase and sale prices.
Each purchase, whether made directly by the investor, or as
a result of a dividend reinvestment, must be calculated separately
from all other purchases, because it will likely be at a different
price than other purchases. Also, each sale consists of certain
shares; and sometimes of groups of shares purchased at different
prices. Sound complicated? It certainly can be, especially
if there are many purchases made over a long period of time,
as can be the case when funds have frequent dividend distributions,
and shareholders automatically reinvest each distribution.
We won't go into more tax detail here, as this is only an
overview of mutual funds. Your accountant is well equipped
to make these mutual fund tax calculations for you. But, do
save your statements from any mutual fund investments you
have, so that each transaction is shown. (Often, a fund's
annual summary statement is all you need to keep.) And, remember
that there's nothing wrong with reinvestment of dividends,
even if it does make tax calculations a tad more time-consuming.
