Last edited Wed Apr 13, 2016, 04:22 PM - Edit history (2)
I have admitted in the past and will say again, I am by no means an accountant or a tax expert, so I want to be careful that I don't misinform.
So....
I own shares in a mutual fund that has been increasing in value at a modest rate. Come tax time, I've been shocked the last two years at the huge "capital gains distributions" (CGD) from the fund that I must pay tax on. How can the "capital gains distribution" be higher that the increased value of the fund?
Because they held on to other shares that decreased in value.
Let's say you have bought shares of the "DU Income and Value Fund". There are plenty of real funds that have similar names, so whenever you see "Income" in the name of a fund, it means they either have a lot of dividend paying stocks or interest paying bonds or both, in other words, they hold positions that generate income.
So the DU I & VF has a share price at the beginning of the year of ten bucks. They hold 100 positions each trading at $10 a share and there are currently 100 shares out there, so the "Net Asset Value" of each share is $10. OK?
During the course of the year, the share price of ABC company spikes to $15 and the manager decides to sell and buy positions in 2 new firms, each priced at $5. He distributes the extra $5 to the shareholders as a capital gain, BUT the NAV of the fund has not changed. Now we have a portfolio of 11 positions, STILL valued at $1000. See?
Of course, most mutual funds have often dozens, if not a few hundred positions, so not only are there gains there can be and are losses as well. Just like you (if you have a taxable trading account), the Mutual Fund can offset gains with losses so that if they equal each other, there is no gains tax.
If a fund holds a stock and the stock price rises the fund should rise the same amount, of course everything else being equal.
Not necessarily. Keep in mind my VERY simplistic example above. A real MF is of course much more complex and the way they determine NAV is by adding up the value of each and every position they have and dividing that by the number of shares held by the fund participants. A large gain in one single position will not necessarily reflect a large gain in the Mutual Fund share price.
BTW, this 'adding up' process is done at the end of the day after each and every trading session for every single Mutual Fund out there. After the closing bell rings, the computers start humming at Vanguard, Fidelity, Dodge & Cox, American Funds, Franklin Templeton and all the rest!
Let's see if I can give an example. Let's say the fund owns a stock that goes up $10 in value. The fund would also go up the same $10. If I sold my fund I would pay tax on that increase. If I didn't sell and the fund sold, their value wouldn't change (still showing a $10 increase in value) and I would be taxed on the $10 profit via CGD. Then if I sold the fund I would again pay for the $10 increase in the funds worth.
Here's the screw up of mine....Original text;
Except that the $10 realized by the fund from the sale is distributed to the shareholders. You have the option of having the MF automatically buy you new shares or you can take it as cash in your account. (I'm sure you know this, just added it for the benefit of any other reader)
Attempt to correct the screw up!;
You said:
"Let's say the fund owns a stock that goes up $10 in value. The fund would also go up the same $10."
Not necessarily as explained elsewhere.
"
If I sold my fund I would pay tax on that increase.
If the share price has risen above your purchase price, then correct.
"
If I didn't sell and the fund sold, their value wouldn't change (still showing a $10 increase in value) and I would be taxed on the $10 profit via CGD"
You are most definitely taxed on any capital gains distribution made by the fund, Yes. But as far as the price of an individual share going up in this scenario, not necessarily, as explained elsewhere.
"
Then if I sold the fund I would again pay for the $10 increase in the funds worth."
If you sell the shares of this Mutual Fund for more than you paid for them, then yes, you will owe Capital Gains tax, just like when you sell a house, or any other asset for more than you paid for it.
This part;
"If I didn't sell and the fund sold, their value wouldn't change (still showing a $10 increase in value) and I would be taxed on the $10 profit via CGD" is not completely accurate. Again, back to the DU I &VF; If the manager held on to that stock that went up to $15 then yes, the share price would increase. But that's not what your scenario is indicating. We are talking about
MUTUAL Funds, held mutually by the shareholders. The manager does not hold cash beyond what the prospectus calls for so if he sells a position and distributes the gain to shareholders, it does not become an increase in share price or NAV.
I know it looks like you are being taxed twice on the same gain, or at least that's what I am getting from you, but again, it is my understanding that the 1099 you get from the MF company takes all of this into account.
If I'm wrong and a tax specialist can correct me, please do so!
= new reply since forum marked as read