Mutual Fund Account Characteristics
Potential Depletion of Principal
Mutual funds always involve a certain amount of risk; neither the principal value nor the rate of return is guaranteed in any way. Both the FINRA (previously known as NASD) and SEC rules require that clients receive a disclosure that investment in a mutual fund may fluctuate in value, and that there is a risk of potential depletion of the principal sum invested.
Minimum Initial and Subsequent Investment
Mutual funds must list in the prospectus the required minimum investment that will be accepted by the fund. The minimum initial investment (anywhere from $250 to $10,000 depending on the fund) may be lowered in certain instances, such as for IRA (or other retirement) accounts or for investors who elect a systematic investment plan. The minimum subsequent investment may be set as equal to, or less than, the initial investment limit.
Dividends and Capital Gains Distributions
When opening a mutual fund account, the investor must elect how to receive dividends and capital gains generated by the fund. The options are:
- To receive distributions as cash
- To reinvest distributions into the fund
- To reinvest distributions into a different fund in the same fund family
The investor may choose a different election for the dividends than they do for the capital gains. Regardless of the option selected, distributions have the same tax consequences for the investor (see the section below on taxation). Also, the investor may change the election at any time.
Mutual Fund Taxation
Mutual funds are regulated investment companies under Internal Revenue Code Subchapter M. Under this subchapter, the mutual fund itself does not pay taxes on investment income, dividends and capital gains. Instead, the mutual fund serves as a conduit – or pass-through – to the mutual fund investors.
In order to qualify, the investment company must register under the Investment Company Act of 1940 and must distribute all, or substantially all (90% or more) of net investment income to the shareholders. Also, 90% of the fund’s income must derive from income from dividends, interest and capital gains from the portfolio’s securities. Finally, at least 50% of the fund must be invested in diversified securities.
Capital gains distributions may be made only once a year and at least 98% of capital gain net income must be distributed. Failure to do so results in a 4% excise tax on the undistributed income. These distributions are typically long-term capital gains only (from sales of securities held for longer than a year). Short-term capital gains (from sales of securities held less than a year) are distributed along with dividends.
Gross investment income is the total amount of dividend and interest income earned by the securities in the fund. Net investment income is calculated by deducting operating expenses (such as management fees, taxes, legal and fees) from gross investment income.
An important concept to know for the exam is net dividend income, which is calculated by dividing the net investment income by the number of outstanding mutual fund shares.
Mutual Fund Distributions and Taxation
Investors receive two types of earnings from investment company shares: dividends and interest from the securities held in the fund portfolio, or investment income, and capital gains that result from the for-profit sale of portfolio securities.
Investment income can be reinvested in the fund or paid in cash to the investor. Either way, it is taxable as ordinary income, depending on the investor’s marginal tax bracket.Qualified dividends are the exception, and are taxable at a maximum rate of 15%.
Capital gains are paid out when the portfolio manager makes sales in the fund portfolio or when the investor redeems shares of the fund at a capital gain, just as they would be incurred by selling a stock for a profit, for example.
- Long-term capital gains result from the sale of assets that have been held for more than a year and are taxed at 15%.
- Short-term capital gains are realized with the sale of assets held for one year or less; they are taxed as ordinary income – that is, at the percentage of the investor’s marginal tax bracket.
Dividends or capital gain distributions are generally taxable when made, regardless of whether the investor reinvests them or receives them in cash.
It is the investor’s responsibility to report mutual fund dividends and capital gains for federal and state tax purposes. Typically, the mutual fund will provide informational reporting on a form 1099, which can be used to complete the taxpayer’s return.