Packaged Securities - Mutual Fund Distributions

Distributions from a mutual fund consist of the following:

The distinction is important for tax purposes.

Dividends
Remember, when your client holds a stake in a mutual fund, she is a shareholder. So, even if it is a bond fund that receives its distributions as interest, to the client as a shareholder of the fund, it is a dividend. Managers can either reinvest dividends back into the fund or distribute them to shareholders. Unless otherwise specified in the prospectus, funds distribute dividends.

  • An ordinary dividend is treated as dividend income on your client's tax return. Short-term capital gains distributed from the mutual fund cannot offset her capital losses realized from other investments.

  • The portion of dividends your client receives from municipal obligations is tax-free at the federal level. Similarly, your client receives the state and local tax exemption from federal obligations.

Capital Gains
Mutual funds may also pay shareholders capital gains distributions from long-term gains realized by the mutual fund. Your client must pay tax on these distributions but at the capital gains tax rate, which might be half of the regular income tax rate.

You can help your client further mitigate capital gains taxes by recommending she sell some investments that are trading at a loss, and subtract those capital losses from the capital gains.


Look Out!
To illustrate, say your client received a $10,000 capital gain distribution from a growth fund. She would probably have to pay about 20%, or $2,000, of that to the IRS.
This is not bad, considering she has a well-paying job and her salary is taxed at 38%, but it is still nothing to cheer about. She also owns some stocks that you have come to regret recommending to her because you told her to buy 100 shares at $70 and they are now trading at $10, so if she sold them she would be out $6,000.
If you advise her to sell the stocks today and realize the $6,000 capital loss, that would offset so much of the capital gain distribution that she would owe $800 to the IRS instead of $2,000. She would still be out $4,800 (the $6,000 loss mitigated by the $1,200 tax shield), but it is better than waiting for that bad investment to turn around, and at least she got some benefit out of it.


In addition to distributing dividends and capital gains, a fund may make a payment to investors that is greater than its earnings and profits. This type of distribution is considered a return of your investment capital and is not taxable
.

Conduit Theory
The notion underlying the above discussion - that mutual funds ought to pass income and capital gains directly onto the investor to avoid double taxation - is called conduit theory.


Exam Tips and Tricks
The Series 7 exam is likely to ask you approximately 50 questions on investment companies, particularly mutual funds. It will also ask you a few questions about variable annuities and REITS.


Variable Annuities
Related Articles
  1. Professionals

    5 Reasons Financial Advisors Still Choose Mutual Funds

    Take a look at five primary reasons why financial advisors still choose to recommend mutual funds over other types of investment vehicles.
  2. Professionals

    Internal Advisor Consultant: Career Path & Qualifications

    Discover more about the responsibilities of an internal advisor consultant, the average salary he can expect and the qualifications he will need for the job.
  3. Brokers

    Broker-Dealer Industry 101: The Landscape

    Independent broker-dealers are a great choice for experienced, self-starter planners who have established practices.
  4. Personal Finance

    RIAs and Brokers: What's the Difference?

    RIAs and brokers are held to different standards when providing investment advice. Here's how they differ.
  5. Trading Systems & Software

    Steps to Starting Up an Independent Broker Dealer

    Launching your own broker-dealer is a lot of work, but the potential payoff is great, both personally and financially.
  6. Professionals

    How To Answer Option Questions On The Series 7 Exam

    Learn how to answer option questions on the Series 7 exam. Pass your Series 7 exam with the help of these tips.
  7. Professionals

    Series 55

    FINRA Series 55 Exam Guide
  8. Professionals

    Series 62

    FINRA Series 62 Exam Guide
  9. Professionals

    Series 99

    FINRA/NASAA Series 99 Exam Guide
  10. Professionals

    Series 65

    FINRA/NASAA Series 65 Exam Guide
RELATED TERMS
  1. No results found.
RELATED FAQS
  1. Do financial advisors need to pass the Series 7 exam?

    The exact nature of a financial advisor's job responsibilities determines whether he must have a Series 7 license. If a financial ... Read Full Answer >>
  2. Do financial advisors have to be licensed?

    Financial advisors must possess various securities licenses in order to sell investment products. The specific products an ... Read Full Answer >>
  3. What are the differences between the Series 6 exam and the Series 7 exam?

    The Financial Industry Regulatory Authority (FINRA) offers a variety of licenses that must be obtained before conducting ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center