The most obvious way to realize earnings from your mutual fund investment is through a capital gain. In simple terms, it’s the difference between your buying price and your selling price of the fund. When you buy low and sell high, the money you make at the sale of your shares is a capital gain.
Just as you can experience a capital gain from buying and selling shares of a fund, a fund itself can also realize profits by selling securities held in the fund. This type of capital gain is passed along to you, the shareholder, in the form of a distribution.
Just as you would receive a dividend from a company by owning a particular stock, mutual funds likewise receive dividends by owning stocks in their portfolios. Mutual funds may choose to distribute those dividends (sometimes called dividend income or “income”) to its shareholders.
Dividends in a mutual fund are usually distributed annually and are considered a taxable event. You may choose to receive your dividend in cash or have the dividend amount reinvested in the mutual fund. Reinvesting can be a good strategy for investors practicing dollar cost averaging.
Mutual funds are required by the IRS to “distribute” any interest, dividends, or capital gains they make each year. These distributions can be confusing because you may still end up paying tax on a distribution even if the fund’s overall performance was negative. In tax exempt accounts, distributions are simply reinvested with no immediate tax requirements and without imposing any eventual tax burden on the account. Although you can receive distributions in cash, you may not realize you received a distribution because you may have opted to reinvest distributions when you first bought the fund. Reinvesting can be a good strategy for investors practicing dollar cost averaging.
Wasatch Funds aims to keep annual distributions roughly aligned with the returns for each fund. By doing this, we even out the burden of taxable distributions for our shareholders, and newer shareholders are not burdened with unrealized gains from previous years. This practice also discourages shareholders from “gaming the system,” or selling before distributions are made, and burdening other shareholders with larger distributions. A fund’s NAV will drop by the distribution amount on the date the distribution is paid, which in turn reduces your ultimate capital gain tax burden when you sell the fund.
There are a few key dates that come into play when determining a distribution from a mutual fund.
The record date is the official date shareholders are “counted” to receive distributions and is determined by the fund company. If you own shares of a fund on this date, you will receive a distribution. This may or may not work in your favor—for instance, if you bought shares the day before the record date, you would be taxed on the distribution for the entire year.
The payment date or distribution date is the day the fund actually pays the distribution to shareholders.