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How Funds Can Make Money
How Funds Can Make Money
What are the three ways to make money in mutual funds?
A chronology of share price movements and distributions
How various fund types distribute profits
Tax consequences of the three types of distributions in unsheltered accounts
Strategies considering taxation of distributions
The three ways to make money in mutual funds
Interest or dividend distributions
Internally generated capital gains
Share price gains
Chronology of share price movements and distributions
- Assume you invest $1,000 in a stock fund on January 10, 1996
- The market moves up through August 15, 1996
- The fund sells shares just before the August peak
- The fund collects dividends and interest throughout the year
- The fund makes a its only distribution on December 21, 1996
- You reinvest your distributions in new shares of stock
|
Date |
Per share information |
Number of shares you own |
Total value of your holdings |
|||
| Accumulated interest and dividends | Accumulated internal capital gains | Underlying value of held securities | Total share price of fund | |||
| Jan. 9, 1996 | $0.00 | $0.00 | 9.95 | $9.95 | 0.00 | $0.00 |
| Jan. 10, 1996 | 0.00 | 0.00 | 10.00 | 10.00 | 100.00 | 1,000.00 |
| Jun. 30, 1996 | 0.50 | 0.00 | 11.50 | 12.00 | 100.00 | 1,200.00 |
| Aug. 15, 1996 | 0.65 | 0.00 | 12.00 | 12.65 | 100.00 | 1,265.00 |
| Sep. 30, 1996 | 0.75 | 1.00 | 9.25 | 11.00 | 100.00 | 1,100.00 |
| Dec. 20, 1996 | 1.00 | 1.00 | 11.00 | 13.00 | 100.00 | 1,300.00 |
| Dec. 21, 1996 | 0.00 | 0.00 | 11.00 | 11.00 | 118.18 | 1,300.00 |
| Jan. 1, 1997 | 0.00 | 0.00 | 11.10 | 11.10 | 118.18 | 1,311.82 |
How various fund types distribute profits
Here is a rough estimate of how various fund types help you make money
Fund type Interest or dividend distributions Internal capital gains Share price gain or loss Money market moderate none none Short-term bond moderate low low Long-term bond high moderate moderate Junk bond very high moderate moderate Blue chip stock moderate moderate moderate Growth stock low moderate to high high Aggressive growth stock low high moderate to high Stock index moderate low high
Tax consequences of the three types of distributions in unsheltered accounts
Interest or dividend distributions
- taxable immediately at highest rates
- receive 1099-DIV each February
- report on Schedule B of form 1040
Internal capital gains
- taxable immediately at possibly favorable rates
- receive 1099-DIV each February
- report on schedule B and Schedule D of form 1040
Share price gains
- taxable only when sold at possibly favorable rates
- receive 1099-B by February of year after sale of shares
- report on Schedule D of form 1040
Strategies considering taxation of distributions
Defer taxation of interest and dividend distributions by sheltering long-term bond, junk bond and blue chip stock funds inside retirement accounts
If already maxed out on retirement account contributions, defer taxation on unsheltered funds by investing in growth stock index funds outside retirement accounts
If the fund is outside of a retirement account, don't invest in the fund right before the fund's distribution date
Mostly applies to stock funds
Most stock funds distribute internally generated gains and other income in December
If you invest in a fund before the distribution date, you'll pay taxes on someone else's gains