Page 371

earnings to report, and therefore no taxes due regardless of how well your stock has done so far. (Note: you would be liable for cash dividends, if any, which are taxed as income.)

Unfortunately this buy and hold tax advantage seldom works with mutual funds and the culprit is the funds' distributions. Fund distributions, as we discussed before, come in two types and are normally taxed under different classifications. The income dividend portion is classified as income and is taxed under whatever tax bracket you might fall under for the particular tax year. However the capital gains portion is taxed under the capital gains class just like when you sell a stock or an option. What I like to emphasize is that unlike stocks, for which as long as you hold them you are not liable for taxes, mutual fund distributions have to be reported regardless of whether or not you sell your shares. Of course, when you do finally sell your mutual fund shares, you would also be responsible for capital gains taxes on whatever amount your NAV returns are on top of the distributions.

Let's look at an example here. Suppose you buy 200 shares of a mutual fund with the NAV of $50 per share. That is a $10,000 initial investment. By the end of the year you decide to sell your shares. The fund's NAV is now $60 and you have also received $1 per share income dividend and $19 per share in capital gains distributions. Your total income dividend would then be

$1 x 200 shares = $200

Your capital gains would be

$19 x 200 shares = $3,800 …