The reinvestment of mutual fund distributions -- dividends and capital gains -- does increase your cost basis. A higher basis is a good thing because you will pay less in capital gains taxes with a higher basis if you sell your fund shares. Tracking your cost basis will prevent double taxation of the distributions paid into your mutual fund account.
Mutual Fund Distributions
Mutual funds are required by law to pay out any net income or realized capital gains to investors. Income can come from stock dividends or bond interest, and most mutual funds pay regular dividends to distribute this income. When a stock or bond is sold at a profit, the result is a realized capital gain. If a fund has net realized gains for the year, those gains are paid out as capital-gains distributions. As a mutual fund investor, you can have these distributions reinvested into more fund shares, compounding the growth of your mutual fund account.
Taxes on Distributions
If you own shares of a mutual fund, the fund will send you a form 1099 at the end of the year listing the amounts of dividends and capital gains paid on your investments. You must claim the distributions on your taxes, even if they were reinvested in more shares. Fund distributions are taxed for the year they were paid; as a result, the reinvestment shares were purchased with after-tax money. From a cost-basis standpoint, buying shares through reinvestment is the same as sending a check to the mutual fund company to buy shares.
Costs Basis Accounting
Your cost basis in a mutual fund account will be the total of the amounts of money you have invested plus the dollar amounts of reinvested capital gains and dividends. The distributions are part of your total earnings from the fund, but since they are taxed when paid, they are also included in your cost of the investment. Keep a record of all of the investment and reinvestment amounts for each of your mutual fund accounts.
Capital Gains Taxes
Capital gains taxes are due on investments that were sold at a profit. The taxable gain is the sale price minus the cost basis. The higher basis from including distribution reinvestments results in a lower taxable gain and less money due in capital gains taxes. If the amount received from selling your fund shares is less than your cost basis, you have a capital loss. Capital losses can be used to offset other capital gains or as a write-off against other income.
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