Mutual Fund Distributions...Don't Overpay Your Taxes
As investment vehicles go, the ubiquitous mutual fund is a pretty convenient animal. In exchange for some expenses that are imposed at the fund level and possibly some sales charges if an investor happens to buy into a fund through a salesperson, he or she receives professional management, the ability to automatically reinvest fund distributions in additional shares of that same fund, and at least a degree of diversification. On net balance mutual funds have been a boon to the individual investor.
As with most things in this world, however, mutual funds do have a few peculiarities – the most noteworthy probably being the fact that the tax code encourages them to distribute most of the income they generate during a given year. In exchange for distributing the lion’s share of their income to their underlying shareholders, funds escape income taxation at their own level. Because this is good for mutual funds as well as for fund shareholders, most funds resolve to make whatever distributions might be necessary to ensure they continue to escape income taxation.
So, now that you know why funds distribute their income to their underlying shareholders, what might that have to do with the overpayment of income taxes? In a nutshell, if an investor later decides to sell a fund that has made distributions such that those distributions were subsequently reinvested in additional shares of that same fund, the likelihood exists that the ensuing gain or loss will be miscalculated to the benefit of the IRS.
What’s the mistake? While fund distributions that are not specifically tax-exempt serve to increase an investor’s "cost basis" in his or her shares, investors often do not realize they need to adjust their cost basis – an adjustment that could be large.
The result? In underestimating the cost of their shares, investors tend to report gains that are artificially large and losses that are artificially small.
