Mutual Fund Accounts - Mutual Fund Characteristics and Taxation

Mutual Fund Account Characteristics

Potential Depletion of Principal
Mutual funds always involve a certain amount of risk; neither the principal value nor the rate of return is guaranteed in any way. Both the FINRA (previously known as NASD) and SEC rules require that clients receive a disclosure that investment in a mutual fund may fluctuate in value, and that there is a risk of potential depletion of the principal sum invested.

Minimum Initial and Subsequent Investment
Mutual funds must list in the prospectus the required minimum investment that will be accepted by the fund. The minimum initial investment (anywhere from $250 to $10,000 depending on the fund) may be lowered in certain instances, such as for IRA (or other retirement) accounts or for investors who elect a systematic investment plan. The minimum subsequent investment may be set as equal to, or less than, the initial investment limit.

Dividends and Capital Gains Distributions
When opening a mutual fund account, the investor must elect how to receive dividends and capital gains generated by the fund. The options are:

  • To receive distributions as cash
  • To reinvest distributions into the fund
  • To reinvest distributions into a different fund in the same fund family

The investor may choose a different election for the dividends than they do for the capital gains. Regardless of the option selected, distributions have the same tax consequences for the investor (see the section below on taxation). Also, the investor may change the election at any time.

Mutual Fund Taxation
Mutual funds are regulated investment companies under Internal Revenue Code Subchapter M. Under this subchapter, the mutual fund itself does not pay taxes on investment income, dividends and capital gains. Instead, the mutual fund serves as a conduit - or pass-through - to the mutual fund investors.

In order to qualify, the investment company must register under the Investment Company Act of 1940 and must distribute all, or substantially all (90% or more) of net investment income to the shareholders. Also, 90% of the fund's income must derive from income from dividends, interest and capital gains from the portfolio's securities. Finally, at least 50% of the fund must be invested in diversified securities.

Capital gains distributions may be made only once a year and at least 98% of capital gain net income must be distributed. Failure to do so results in a 4% excise tax on the undistributed income. These distributions are typically long-term capital gains only (from sales of securities held for longer than a year). Short-term capital gains (from sales of securities held less than a year) are distributed along with dividends.

Gross investment income is the total amount of dividend and interest income earned by the securities in the fund. Net investment income is calculated by deducting operating expenses (such as management fees, taxes, legal and fees) from gross investment income.

An important concept to know for the exam is net dividend income, which is calculated by dividing the net investment income by the number of outstanding mutual fund shares.

Mutual Fund Distributions and Taxation
Investors receive two types of earnings from investment company shares: dividends and interest from the securities held in the fund portfolio, or investment income, and capital gains that result from the for-profit sale of portfolio securities.

Investment income can be reinvested in the fund or paid in cash to the investor. Either way, it is taxable as ordinary income, depending on the investor's marginal tax bracket.Qualified dividends are the exception, and are taxable at a maximum rate of 15%.

Capital gains are paid out when the portfolio manager makes sales in the fund portfolio or when the investor redeems shares of the fund at a capital gain, just as they would be incurred by selling a stock for a profit, for example.

  • Long-term capital gains result from the sale of assets that have been held for more than a year and are taxed at 15%.
  • Short-term capital gains are realized with the sale of assets held for one year or less; they are taxed as ordinary income - that is, at the percentage of the investor's marginal tax bracket.

Look Out!
Dividends or capital gain distributions are generally taxable when made, regardless of whether the investor reinvests them or receives them in cash.

It is the investor's responsibility to report mutual fund dividends and capital gains for federal and state tax purposes. Typically, the mutual fund will provide informational reporting on a form 1099, which can be used to complete the taxpayer's return.

Selling Mutual Fund Shares
Related Articles
  1. Retirement

    How Much Money Do You Need to Retire at 56?

    Who wouldn't want to retire early and enjoy the good life? The question is, "How much will it cost?" Here's a quick and dirty way to get an answer.
  2. Retirement

    The Best Strategies to Maximize Your Roth IRA

    If a Roth IRA makes sense for you, here are ways to build the biggest nest egg possible with it.
  3. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  4. Personal Finance

    Is An Ivy League Degree Worth It?

    In 600 B.C. Aesop determined that a bird in the hand was worth two in the bush. Warren Buffett claims that this axiom can be used to determine the most valuable uses of capital. In this article ...
  5. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  6. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  7. Retirement

    Suddenly Pushed into Retirement, How to Handle the Transition

    Adjusting to retirement can be challenging, but when it happens unexpectedly it can be downright difficult. Thankfully there are ways to successfully transition.
  8. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  9. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  10. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  1. Brand Identity

    Brand identity is the way a business wants consumers to perceive ...
  2. Elastic

    A situation in which the supply and demand for a good or service ...
  3. Earnings Stripping

    Earnings Stripping is a commonly-used tactic by multinationals ...
  4. Skinny Down Distribution

    Skinny down distribution is corporate practice of slimming down ...
  5. Education Loan

    Money borrowed to finance education or school related expenses. ...
  6. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  1. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  2. Is Israel a developed country?

    Israel is considered a developed country, although it has substantial poverty and large income gaps. The International Monetary ... Read Full Answer >>
  3. Can personal loans be included in bankruptcy?

    Personal loans from friends, family and employers fall under common categories of debt that can be discharged in the case ... Read Full Answer >>
  4. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  5. Is the Wall Street Journal considered to be a conservative publisher?

    The Wall Street Journal is controlled by Rupert Murdoch via Dow Jones Publications, which in turn is owned by Murdoch's News ... Read Full Answer >>
  6. Is Spain a developed country?

    Spain is a developed country. Nearly all organizations that analyze development status classify it as such. Spain has a strong ... Read Full Answer >>
Hot Definitions
  1. Take A Flier

    The slang term for a decision to invest in highly speculative investments.
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center