Mutual funds can hold a variety of stocks, bonds or other securities. When those securities pay dividends or interest, that income is passed along to the mutual fund investors. If securities held by a fund are sold at a profit, those profits may also be distributed to the mutual fund investors. Owners of mutual fund shares should know how fund distributions work and the different types of distributions that are possible.
Dividends and capital gains are the two types of mutual funds distributions. If a mutual fund holds stocks that pay dividends or debt securities that pay interest, it is required to pass that income through to investors in the form of dividends. Most stock mutual funds pay dividends quarterly, and many bond funds pay monthly.
If a mutual fund sells securities at a profit and does not have offsetting losses, it must pay out the profits as capital gains distributions. Most funds pay capital gains, if there are any, once a year.
On the day a distribution is paid to shareholders (the ex-dividend date), the mutual fund share price, or net asset value (NAV), will decrease by the amount of the distribution. The distribution can be paid in cash to the shareholder or automatically reinvested in additional shares of the fund. If distributions are reinvested, the account value will be the same before and after the NAV drops to reflect the payout. Between distribution dates, earned income and profits are reflected in the NAV of the fund.
Mutual fund distributions must be included on your income tax return. Distributions can be ordinary dividends, qualified dividends, long-term capital gains or short-term capital gains. These categories all have different tax rates. IRS Form 1099 from the mutual fund will specify the categories of the distributions.
If mutual fund distributions are reinvested into additional shares, the mutual fund account will grow in shares and value over time. Owners of mutual fund shares must realize the value of their account is not merely indicated by the listed share price but also by the increasing number of shares from reinvested dividends.
Most mutual funds make capital gains distributions near the end of the calendar year. If the fund has had a good year, the distributions can be significant. If you purchase mutual fund shares just before a distribution, you will receive the distribution without benefiting from a gain in your account value. You will receive a Form 1099 for the amount of the distribution and must include it on your income taxes.