I own a few mutual funds, and once or twice a year most of them pay a dividend-part capital gains and part interest income. The IRS says this is taxable income.
On the date this dividend is paid, however, the value of my fund shares drop by the exact amount of the dividend payment. (If the dividend is 25 cents a share, the value of my shares drop by 25 cents.) So, how can the IRS say this is a profit?
Your gains are real, though the value of your mutual fund shares may decline.
If you own a stock fund, for example, some of the stocks in that fund may pay dividends. Or, cash in the fund may earn interest income. Someone must pay tax on that money.
Mutual funds are not required to pay tax, as long as they distribute to shareholders at least 98 percent of all earnings and capital gains. Instead, the tax is passed on to the fund’s shareholders.
Even if the value of your fund stays the same all year-or if the value declines, for that matter-you still may have capital gains or interest income.
If you think you have it bad, think of the folks who buy mutual fund shares just before a dividend payment is made. They are taxed on money that was earned by the fund before they became shareholders. So, in effect, they are taxed on money they never received.
For that reason, investors generally should avoid buying into a mutual fund just before a dividend payment is scheduled.
