Distributions and tax implications of mutual funds

We all know that the economy is struggling right now. The financial crisis that started as a mortgage crisis is now a big world wide crisis that we all need to face. Whether we want to or not, we will have to face the crisis and find out about how to fix it. We might not have got ourselves into this mess, but we will have to become smart if we want to get ourselves out of it. Education will be a big part of fixing the problem and preventing it from happening again. We will also have to fight greed and other forms of corruption that have become far to wide spread in our economy and society. In order to become educated about the economy and the stock market, we should probably learn something about the ways that mutual funds are run. These are very important parts of the economy and constitute a good portion of investment. So how do mutual funds work and what are the tax implications of distributing returns on mutual funds?

As you may know, every year mutual funds have the option of distributing the money they have earned through trading. These are called dividends. The company distributes its dividends to its shareholders because if it does not it will have tax liability for that income. If these earnings are distributed to the shareholder then the shareholder becomes liable for paying taxes on these dividends. Depending on the type of mutual fund you have, the fund could distribute these earnings or dividends as frequently as monthly, or as infrequently as annually. Because allot of these funds will pay their dividends late in the year, you should be careful to not buy into a fund just before it is about to pay out. The problem is that you will almost immediately receive your earning back with a tax bill. Always check and see when the fund plans on distributing its dividends before you invest.

As you can see, it makes a big difference to know some basic things about the way that dividends are taxed. As a potential investor you want to know how frequently your fund distributes its dividends and you want to know if they will be doing so right after you invest. Make sure that mutual the fund you are investigating has a good reputation and a good history of success. Do not make an investment without any kind of research, and realize that you need to diversify your investments. This is particularly true when we are in such a terrible economic situation. If you invest all of your wealth in just one option you face the risk of loosing it all when that option falls apart. If you can research multiple investments and invest in several different options you stand to loose much less, and potentially to gain. In such a difficult situation you need to spread your wealth around. Diversifying will be an important part of what you do as an investor in the troubled economy.

It is not difficult to gain a little bit of education about the way mutual funds and taxes work. These are not particularly complicated funds or taxes, but they can make a big difference. If you want to become a responsible investor you need to learn about things like this. A good investment can help you to ensure your family's financial future. Don't give up on investing even in such difficult times. Some investors fins that they can actually make more over the long run by buying during a recession and then waiting on their investments.

And it's important not to lose sight of the big picture. For a mutual fund investor who saw the value of their investment appreciate nicely between the time of purchase and the distribution, a distribution just means more taxes this year but less tax when the shares are sold. Of course it is better to postpone paying taxes, but it's not as though the profits would be tax-free if no distribution were made. For those who move their investments around every few months or years, the whole issue is irrelevant. In my view, people spend too much time trying to beat the tax man instead of trying to make more money. This is made worse by ratings that measure 'tax efficiency' on the basis of current tax liability (distributions) while ignoring future tax liability (unrealized capital gains that may not be paid out each year but they are still taxed when you sell).

So what are the tax implications based on the timing of any sale? Actually, for most people there are none. If you sell your shares on Dec. 21, you have $2 in taxable capital gains ($1 from the distribution and $1 from the growth from 8 to 9). If you sell on Dec. 22, you have $1 in taxable capital gains and $1 in taxable distributions. This can make a small difference in some tax brackets, but no difference at all in others.