Packaged Securities - Mutual Fund Distributions
Distributions from a mutual fund consist of the following:
The distinction is important for tax purposes.
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.
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.
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.
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.