Question

Discuss how transfers and distributions are taxed differently. Explain why.

Answer 1

Unless you own your mutual fund through a 401(k) plan, an IRA, or some other type of tax-deferred account, you'll owe taxes on that distribution, even if you reinvested it (used the distribution to buy more shares of the fund). That is particularly painful if you have just purchased the fund because you are paying taxes for gains you didn't get.

Let's use an example to illustrate. Suppose you invest $250 in Fund D on Monday. The fund's NAV is $25, so you are able to buy 10 shares. If the fund makes a $5-per-share distribution on Tuesday (which means you have been handed a $50 distribution), and you reinvest, your investment is still worth the same $250:

Monday	10.0 shares @ $25	=	$250
Tuesday	12.5 shares @ $20	=	$250

The trouble is, you now owe capital-gains taxes on that $50 distribution. The current long-term capital-gains tax rate is 15% for anyone in the 25% or higher bracket and 5% for those in 10% to 15% brackets. If you're in the higher tax bracket, you'd have to pay $7.50 in taxes on that long-term capital gain. (Shorter-term capital gains are taxed at a higher rate.)

If you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. The distribution lowers the NAV, so the amount of taxes you would pay would be lower than if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner. And we're guessing that if you just invested in the fund, you weren't planning to turn around and sell it right away.

Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, you can lose money in a fund and still have to pay taxes. In 2000, for example, many technology funds made big capital-gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital-gains as a result. Technology-fund investors lost money to both the market and Uncle Sam that year.

The same thing happened to some funds in 2008. If a fund sold stocks that year (particularly earlier in the year before the market freefall) that had been purchased at lower prices, and could not offset those gains with any realized losses, then investors would have been on the hook for fund capital gains taxes in 2008--one of the worst years for the market in recent history.