Mutual funds sell shares and use the incoming money to buy various securities, primarily stocks, bonds and money market tools, depending on the strategy of the fund. So, you and other fund shareholders effectively own a piece of each of the fund's underlying securities. Because a mutual fund is organized as a pass-through vehicle, the law dictates that fund income — whether from interest, dividends or gains from the marketplace sales of the underlying securities — be passed along to shareholders through periodic distributions.
While capital gains distributions are taxed used the capital gains taxation infrastructure implemented by the IRS, income dividends are taxed according as standard income.
Exploring Various Distribution Types
Mutual funds typically issue three kinds of distribution: dividend, short-term capital gain and long-term capital gain. For example, after a company collects the dividends from its underlying securities over a specific period of time, the accumulated amount is divided by the number of outstanding fund shares to determine the dividend distribution.
Capital gains distributions are figured similarly. Securities sold during a specified time frame generate either a market gain or loss. If the gains exceed the losses, the profit is divided by the number of fund shares and is passed on as a capital gain distribution.
Evaluating the Distribution Schedule
A fund can issue distributions on any timetable it chooses, although most funds employ a regular and publicized schedule. Typically, dividend distributions are made monthly or quarterly, and capital gains distributions come once or twice a year.
Understanding Dividend Distributions
Dividend distributions include all kinds of income except for capital gains. Distributions paid as a result of dividends from U.S. and foreign corporations may be qualified dividends, meaning they are taxed at the dividend rate equivalent to their general income level, that being 0 percent, 15 percent or 20 percent.
Distributions paid with money on dividends from federal government bonds, corporate bonds and many preferred stocks, as well as those from companies organized as trusts, partnerships or business development companies, are taxed as ordinary income.
Some dividend distributions — if the underlying securities are municipal bonds, for example — can be tax-exempt. The mutual fund will specify what part of an income dividend is taxable, and whether that part is qualified, on the 1099-DIV statement that you receive before you file your taxes.
Capital Gains Distributions
If the mutual fund holds an underlying security for more than a year before selling it for a profit, the resulting distribution is taxed at the long-term capital gains rate. Securities held less than a year by the fund result in short-term capital gain distributions, which are taxed as ordinary income. If the fund has net losses on its sales for any year, no capital gains distribution will be made, and those losses can be used to offset gains in succeeding years.
Factoring in Share Price
Each day a mutual fund computes its net asset value, which is the total of that day's closing value for all the underlying securities plus the cash on hand from dividends or sales of securities, divided by the number of shares issued by the fund. When a fund gets a dividend from one of its securities, the net asset value of the fund goes up to reflect the cash received. When a fund pays a distribution — say, 7 cents a share in a dividend distribution — the net asset value of the fund drops by that amount.
Digging Deeper Into Reinvested Distributions
Most mutual funds allow you to reinvest your distributions in additional shares of the fund. Unless you hold the fund in a tax-deferred account, such as an individual retirement account or a 401(k) plan, you must pay tax on the reinvested distribution as if you had received it in cash.