When a mutual fund makes a profit, the fund distributes the profits to its shareholders. These distributions are typically in the form of a dividend or interest income payment. Shareholders have the choice to receive a direct payment for the gains or reinvest them in the fund by purchasing additional shares. Investors face tax consequences whether they decide to receive a payment or reinvest their profits in the fund.
Selling Fund Shares
When you sell mutual fund shares for more than the original purchase price, you make investment income. The IRS taxes this income at your capital gains tax rate. The tax rate at that applies to your income depends on your regular income tax bracket and can range anywhere from 0 to 28 percent. Capital gains tax rates can vary each tax year depending on the changes in the federal tax laws.
Mutual funds buy stocks and bonds, some of which earn dividends and yields, respectively. When the securities held by the fund earn income in the form of dividends and yields, the fund must distribute this income to its shareholders. The IRS considers these distributions as investment income. The shareholders then have to pay capital gains taxes on the amount of their individual distributions.
Capital Gains Distributions
When a mutual fund manager sells securities held in the fund for more than their original purchase price, the fund makes a capital gain. When the manager sells them for less than the original purchase price, the fund makes a capital loss. If the fund's gains are not offset by the fund's losses, it makes an overall gain. The fund must make a capital gains distribution to its shareholders. The shareholder's pay the capital gains taxes on the amount of their individual capital gains distributions. This is in addition to the taxes they must pay on their regular distributions.
If a mutual fund makes regular or capital gains distributions at any time during the year, shareholders have to pay the capital gains taxes on these distributions. This is true even if at the end of the year the fund ended up losing value, causing the overall value of the shareholder's investments in the fund to decrease. Put more simply, if the fund makes a capital gains or regular distribution in September, but ends up in the red in December, the shareholders still have to pay the taxes on their distributions even when the overall value of their investment has decreased.