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. Taxes

    Tax Breaks For Volunteering

    Your volunteer ventures could earn you some welcome tax deductions, along with the satisfaction of helping others.
  2. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  3. Retirement

    Is Working Longer A Viable Retirement Plan?

    Fully funding someone’s life for three decades without work is tricky. The result is retirement has become, for many, a 30-year adventure.
  4. Retirement

    Don’t Retire Early, Change Careers Instead

    Though dreamed of by many, for most, early retirement is not a viable option. Instead, consider a midlife career change.
  5. Taxes

    Six Ways Your Tax Preparer Knows You’re Lying

    Cheating on your taxes is asking for trouble. You might get away with it, but you’re playing with fire and likely to get burned.
  6. Budgeting

    Preventing Medical Bankruptcy

    If you’re worried medical expenses could overwhelm you, there are some thing you can do to ease your concerns.
  7. Insurance

    Medicare 101: Do You Need All 4 Parts?

    Medicare is the United States’ health insurance program for those over age 65. Medicare has four parts, but you might not need them all.
  8. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  9. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  10. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  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. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  2. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  3. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  4. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  5. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  6. Can FHA loans be used for investment property?

    Federal Housing Administration (FHA) loans were created to promote homeownership. These loans have lower down payment requirements ... Read Full Answer >>
Hot Definitions
  1. Turkey

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

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

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center