19-07-2013, 03:09 PM
Distributions and Mutual Funds
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What are Distributions?
Mutual funds are collections of stocks, bonds, and other financial securities mu-
tually (jointly) owned by a group of people. Thus, when one purchases one share
of a mutual fund, one is effectively purchasing, for example, 0.03 shares of Intel,
0.05 shares of Exxon, $3.00 of a 30-year U.S. Treasury bond, and 2.34 shares of
Stockmaster.
Most mutual funds frequently buy and sell stocks and bonds so, even though
you may still own one share of the same mutual fund, it know could now represent
0.4 shares of Compaq, 0.03 shares of Dow Jones, and 2.34 shares of Stockmaster.
When the mutual fund company sells some securities for a higher price than it
originally paid for them, a capital gain occurs. If it sells for a lower price, a
capital loss occurs. A stock or bond owned by the mutual fund may also pay a
dividend, that is, cash paid by the stock or bond. Distributions consist of capital
gains, capital losses, and dividends paid to mutual fund shareholders.
Why, When, and How do Mutual Funds Pay Dis-
tributions?
To avoid paying taxes themselves, mutual fund companies pay almost all capi-
tal gains and income to shareholders. When these people receive the gains and
income, they, not the mutual fund company, owe taxes on the amounts.
Most mutual fund companies pay distributions once or twice a year. Although
they buy and sell securities throughout the year and stocks pay dividends at dif-
ferent times during the year, the cost of bookkeeping and mailing statements to
shareholders limits the frequency of distributions.
Financial Impact of Distributions
A mutual fund’s price (net asset value) will drop on the record date by the amount
of the distribution. In our example, one share of Fidelity Select Electronics Fund
2was worth $37.65 the day before the record date. The instant the stock market
opened on the record date, its per-share value dropped by the amount of the dis-
tribution, i.e., $6.95. Nobody has gained or lost money. Some of the share’s value
has been converted to cash. One share is now worth $30.70 plus $6.95 in cash.
(During the day, the stocks and bonds that Fidelity Select Electronics owned did
decrease 3.6% in value, but this is unrelated to the distribution.)
The shareholder owes taxes on the distribution. The long-term capital gains
are taxed at the long-term capital gains rate while short-term capital gains and
dividends are taxed as ordinary income.
How do Distributions Affect When I Should Pur-
chase a Fund?
Generally, one should not purchase a mutual fund a few days before the record
date to avoid owing taxes on the entire distribution. Suppose we purchased $10,000
of Fidelity Select Electronics Fund at $37.65 per share the day before the record
date. Since we owned 265.6 shares on the record date, we would receive a dis-
tribution of $1845.95. We neither gained nor lost money, but some of it has been
converted into cash. Unfortunately, the distribution is taxed so we’d pay income
taxes on the $1845.95. Thus, it’s generally a good idea to purchase mutual funds
after, not before, record dates.
Some mutual funds actively trade securities, generating a large amount of
short-term capital gains. Owning these mutual funds means one must pay taxes,
at one’s ordinary income tax rate, every year. If you use your distributions to pur-
chase more shares, you’ll need to find other cash to pay your income taxes on the
distributions.
Others trade very infrequently, generating very small amounts of distributions.
Thus, your annual income taxes will be lower. The taxman still cometh, however.
When selling these funds, one has to pay capital gains taxes. Since long-term
capital gains are taxed at lower rates than short-term capital gains, you can still
reduce your tax bill. Thus, mutual funds rated with the highest annual appreciation
may not yield the largest after-tax appreciation.
All these taxing problems are avoided for mutual funds held in tax-deferred
accounts, e.g., IRAs. For these, there’s no need to pay income taxes and no need
to worry about record dates.