Mutual funds are pooled investments that give you the opportunity to own a piece of a diversified portfolio through a single transaction. The principal amount of your mutual fund investment is your cost basis -- the amount you paid to buy the shares, including fees and commissions. You use your cost basis to figure your tax obligations arising from buying, selling and owning mutual fund shares.
Net Asset Value
Mutual fund shares trade at their net asset value, the portfolio assets minus its liabilities, divided by the number of shares outstanding. When you buy shares of a mutual fund, the fund company records a tax lot containing the date of purchase, the number of shares, the share NAV and any fees or commissions. The tax lot therefore books the principal amount of each purchase. When you sell shares, the mutual fund matches the tax lots to the sell order to determine your gain or loss -- your sale proceeds minus the shares' cost bases recorded in your tax lots. You pay taxes on the capital gains from the sale, not on your principal amount. If you held the shares for more than a year, you receive long-term capital gains treatment -- a tax break.
Taxes on Mutual Fund Shares
Mutual fund companies don't pay taxes; they pass that obligation onto shareholders. Funds distribute all of their dividends, interest and capital gains every year, and these distributions are usually taxable income -- the interest from tax-exempt municipal bond funds being a familiar exception. Mutual funds accrue their interest, dividends and capital gains until they realize the income as a distribution to shareholders. While the income remains unrealized, it accumulates within the share NAV. At distribution, the fund reduces the NAV by the realized amount of income.
Buying the Distribution
You "buy the distribution" when you purchase mutual fund shares just before a dividend or capital gains distribution. This creates immediate taxable income. For example, suppose you purchase 100 shares of a mutual fund for $15 a share on Monday. On Tuesday, the fund realizes and distributes $5 a share from unrealized capital gains. You receive $500 in capital gains, and you may feel that you just incurred tax on your principal amount. You did not. You still own 100 shares, now priced at $10 each. If you were to sell them on Tuesday, you would take a $500 capital loss, completely offsetting the capital gains distribution. The result: no taxable income.
Reinvestment of Distributions
You may instruct your mutual fund to reinvest dividends and capital gains distributions, or you may instead take those distributions as cash. The taxes are the same either way. If you automatically reinvest your distributions, you create new tax lots at the then-current NAV. Later, when you sell shares, you inspect these tax lots to figure your capital gain. Unless it's tax-free interest, the distribution immediately creates taxable income, but this is not tax on your investment principal.
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