Mutual fund investors are often bewildered by the tax ramifications of various types of actions or events that may give rise to a tax liability. As a rule, mutual fund shareholders are subject to tax upon the receipt of fund distributions or upon the sale, exchange or redemption of their fund shares. To fully understand the tax implications of these events we should consider the differences in the kind of distributions that mutul funds make.

Basically, mutual funds earn investment income in the form of dividends and interest on the securities owned. Their value also grows in the form of capital appreciation resulting from price changes in the fund's portfolio securities. The capital appreciation, or losses, may be realized or unrealized, depending on whether the fund has disposed of the securities. Most funds are not taxed on these capital gains because they qualify for "conduit" status by distributing at least 90 percent of all net investment income and net realized capital appreciation.

Therefore, it is the shareholders, rather than the mutual fund, who are subject to the potential tax liability on this income. Even if the shareholders are automatically reinvesting in additional fund shares, they must still report the distributed income.

By the end of January each year, mutual funds are required to send a Form 1099 to their shareholders. The 1099 statement, a copy of which is also sent to the IRS, shows the various types of distributions that were made during the previous year. The type of distribution will determine the recipient's tax return accounting.

The three most common types of mutual fund distributions are:

Ordinary Dividends: These represent net investment income, i.e., cash dividends and interest received, less allowable fund operating expenses. The income is taxed as ordinary income on the shareholder's federal tax return.

Capital Gains Distributions: At the end of each year, appreciation and losses realized through securities transactions are netted and any excess realized captial gains are generally paid to the shareholders. Distributions of capital gains are subject to taxation as ordinary income. If a net loss results, the fund may carry the loss forward for up to eight years to offset future capital appreciation.

Exempt Interest Dividends:  Some mutual funds invest in state and municipal bonds. Interest from such obligations may be taxable on the investor's state income tax return but exempt from federal income tax. If a mutual fund invests in U.S. government obligations, the interest income is subject to Federal tax, but is exempt from state tax.

Purchases and Sales of Mutual Fund Shares
Increases or decreases in fund income, whether realized or not, are immediately reflected in the fund's net asset value (NAV). These increases or decreases in the per share NAV may result in a realized gain or loss to the shareholder at the time the shares are sold.

The amount of gain or loss is determined by the difference between the price at the time of sale and the adjusted cost basis of the shares. Some of the shares, for example, may have been acquired through automatic reinvestment of prior distributions. The cost basis of these shares is the per share NAV at the time they were acquired. Since these distributions have been previously subject to taxations, ignoring the cost of shares acquired in this manner could result in an overpayment of income taxes.

Sales commissions and brokerage fees are treated as an adjustment to the cost basis and reduce the capital gain or increase the capital loss when the shares are redeemed. These costs are not deductible as investment expenses on the investor's tax return. Also, within certain limits, investors may deduct the interest expense on money borrowed to buy mutual fund shares, unless the shares are in a tax-exempt mutual fund.

Timing of Transactions
When a mutual fund declares a capital gain or income distribution, it selects a record date. Shareholders of record on that date will receive the distribution, even if they sell their shares by the time the distribution is actually made. Since it takes five business days to deliver shares in a regular trade, the per share NAV of the fund will fall by the amount of the distribution shortly before the record date.

This date is known as the "ex-distribution date." Individuals who purchase mutual fund shares immediately before the ex-distribution date effectively have a portion of their investment capital returned to them. Even though the distribution equals the decrease in the NAV, the investor's relative position may be lowered by the amount of tax that must be paid on the distribution.

It is generally advisable, therefore, to refrain from making mutual fund purchases immediately before the ex-distribution date. Investors can easily find out when capital gain and income distributions will be made by contacting a representative of the mutual fund.