Mutual Fund Tax on Dividends and Capital Gains

**safari** · 11-30-2006, 02:53 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Yes, it's true. Mutual funds distribute their capital gains to investors, usually sometime in December. They are obligated to do so by law. It doesn't matter if you choose to receive your distributions in cash or reinvest it in the same fund, you still will have to pay the tax on that amount. That's why it's not recommended to purchase mutual funds just before the distribution takes place because you'll incur a tax liability, even if you didn't make any money from that investment. In fact, it's possible that you may have to pay tax on capital gain distributions even if you lost money in the fund because the fund could have sold some stocks it held previosly with a gain, which you will receive as a distribution. Your particular example is correct, when a fund makes a distribution, its share price goes down, but the market value of your holdings remains the same, you just own more shares of that fund (if you chose to reinvest). Your numbers are incorrect though. If you invest $1000 in a fund that costs $10 a share, you'll own 100 shares. So if it pays $0.10 a share, then your taxable distribution would be $10.

If you use mutual fund NAV price charts to analyze a fund's performance, you have to keep in mind that yearly sharp declines in NAV price are nothing other than distributions, which may give you a wrong idea about fund's performance.

Another thing I'd like to point out is that your capital gain distributions should be added to the cost basis, so you wouldn't have to pay taxes twice on that amount. For example, you purchased $10,000 worth of a mutual fund. This is your cost basis. Later you received a capital gain distribution in the amount of $100. You'll have to pay taxes on that $100 when you file taxes for that year. But now your new cost basis becomes $10,100. If you later sell your shares for $11,000, your capital gain is going to be $900, instead of $1,000. It's a common mistake that many people make and end up overpaying taxes.

**kristinecfp** · 11-30-2006, 02:58 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Originally posted by risknothing

I own a mutual fund that will be paying short term and long term capital gains along with a dividend at the end of the year. I want to invest more money into the mutual fund but would that be a bad idea based on the taxes i would incur? Or would it still be good because of the capital gains?

It does make a difference when you purchase a mutual fund.

If your mutual fund is in a taxable account (not an IRA or other tax deferred retirement account), then you are essentially buying a tax liability if you purchase a mutual fund right before the dividend/capital gain distribution date.

So, if you are interested in purchasing a mutual fund that is going to be making a dividend/capital gain distribution, it is best to wait until after the distribution date.

**risknothing** · 11-30-2006, 06:55 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

So your saying that if the fund says it is paying an 8% dividend that the share price is going down 8 %? That seems strange that i would be paying taxes off the same amount of money i invested.

**risknothing** · 12-04-2006, 06:16 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Would it be smart to sell the fund before the capital gains and then buy it back? Would you be better off?

**ren** · 12-04-2006, 06:55 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Don't do that! You'll be taxed at the higher capital gains rate (a.k.a. your normal tax rate) on all the growth for the last year, which is (hopefully) more than being taxed on just the dividend.

**risknothing** · 12-04-2006, 07:26 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Well I just recently bought it not completely understanding the capital gains and dividends. It is up 3% since i bought it and it will soon pay a 8% capital gains. The fund is Vanguards International Growth Fund.

Explain to me how capital gains and dividends benefit me? They seem to just make my gain realized and taxable.

**creditcardfree** · 12-05-2006, 06:35 AM

Re: Mutual Fund Tax on Dividends and Capital Gains

Dividends are the earnings that companies are paying out to their shareholders (some companies don't pay dividends...but reinvest their earnings in to their company). When you own a mutual fund these are required to be passed on to you as a shareholder. They could pay these to you in cash...so your benefit would be more cash in your pocket. Generally, dividends from your mutual fund are reinvested, which means that cash buys you more shares in the mutual fund...more shares to appreciate in price.

Capital gains occur when the mutual fund company has to sell some of the company stock in the fund and it is sold at a price greater than what they bought it for. Mutual funds sell stock for several reasons...one of which is to pay mutual fund owners who take a distributions from their individual account. They also sell when they are reallocating the fund composition...maybe they had too much money in that one stock.

Both of these are passed on to all shareholders. Tax deferred accounts...such as ira's are not subject to tax on these distributions, because they are paid at a later date in the form of price appreciation.

Because you own this mutual fund in a taxable account you will pay taxes on the gains because it is considered current year income to the irs. It is similar in some respects to having a savings account and earning interest...the irs still considers that interest income for tax purposes.

Bottom line, capital gains and dividends benefit you because they are a return or earnings on your investment. The irs tax rules require you pay tax on those earnings. In the long run, you will still be ahead with your investment if it continues to increase in price and pays you dividends.

**risknothing** · 12-05-2006, 01:36 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Well what i am understanding is that capital gains reduces the price of the mutual fund stock. So if a fund pays a $1 dividend or capital gain then the price of the stock will go down $1. So I end up with the same overall value.

**kv968** · 12-05-2006, 03:14 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Originally posted by risknothing

Well what i am understanding is that capital gains reduces the price of the mutual fund stock. So if a fund pays a $1 dividend or capital gain then the price of the stock will go down $1. So I end up with the same overall value.

If the dividends and capital gains are reinvested in that fund then that's correct, you will end up with the same overall value. If however you take the capital gains and dividends as a payout, then you get the $1/share in cash and your share still drops a $1. It's not really money for nothing.

**kv968** · 12-05-2006, 03:34 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

One other thing about this fund. It charges a 2% fee on shares redeemed within two months of their purchase to discourage people from trying to time the market. So if you've bought them within the past two months that's another fee you'll incur. Regardless, I think you should just hold onto the fund but definitely wait until after the distribution to purchase more.

**risknothing** · 12-05-2006, 03:36 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

How may mutual funds should i spread my money through? I have two now.

Target Retirement 2045
International Growth Fund

I want to pick another to diversify more but i think these touch almost everything.

**disneysteve** · 12-05-2006, 03:41 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Originally posted by risknothing

How may mutual funds should i spread my money through? I have two now?

This is an entirely different subject and I suggest you start a new thread to get answers to this question.

An argument could be made today for holding just one fund, a targeted retirement fund, and I'm sure there are a fair number of people who will do just that. But that assumes your only fund investing is for retirement.

An argument could also be made for holding 3 funds: a total US stock market index, a total bond market index and an International stock index.

And, of course, lots of other opinions will come your way. Personally, I currently own 10 funds, not counting my money market fund. I probably don't need them all at this point but just picked up 2 of them when we started investing in my wife's 403b. That caused some duplication of fund types which I may do away with in the coming year and knock the total down to 9 or 8.

**kv968** · 12-05-2006, 03:53 PM

Re: Mutual Fund Tax on Dividends and Capital Gains

Unfortunatley that's not a question that can be readily answered. What I mean, is there is no "right" number. You have to take into consideration quite a few of things (ie. risk tolerance, asset allocation, length of investment, IRA or taxable, etc...). What's right for me won't be right for you. Here's a look at portfolios with a various number of funds:

http://www.marketwatch.com/News/Story/Story.aspx?guid={DB2FE1FE-444D-4D59-AF7B-3BF006881A2E}

If you're looking for a retirement fund, one fund that does it all (ie. balance and rebalance) would be a Target Retirement Fund. Vanguard, T Rowe Price and Fidelity offer good ones. With those you just pick the year you're planning to retire and invest in that fund. It automatically rebalances your stock/bond ratio and risk tolerance as you near your target date.

Mutual Fund Tax on Dividends and Capital Gains