Mutual Funds 101

Mutual funds offer a way to have your money managed as part of a large pool of money contributed by many investors. You gain two big advantages:

• Diversification. It’s important to have your money divided among many different investments. As a mutual fund investor you share in the performance of all the investments made by the mutual fund, so you can have the advantage of diversification without maintaining a large number of different investments.
• Professional management. Mutual funds have professional investment managers so you don’t have to handle this yourself.

How it works

A mutual fund account can be similar to a bank account. You get started by filling out forms and writing a check for the initial deposit. After that you can make additional deposits and, when you need the money or want to make a different investment, take a withdrawal.

There are important differences though. A bank account doesn’t lose value unless you withdraw money. In a mutual fund your account balance can decline if the investments lose value. That risk is the price you pay for the higher rate of growth that’s possible from a mutual fund.

Here’s another important difference: as a mutual fund investor you aren’t simply depositing and withdrawing cash, you’re actually buying and selling shares of the mutual fund. This won’t matter much if you hold your mutual fund investments in an IRA or other retirement account. In a regular taxable investment account it matters a great deal. Every time you take money from a mutual fund account you’re selling shares, and you have to report gain or loss from that sale on your tax return.

All in the family. A mutual fund company may offer a variety of different funds and make it easy to move your money from one fund in this “family” to another. Even though you don’t receive any money in this transaction you’re considered to be selling shares in one fund and buying shares in another, and you’ll have to report the sale on your tax return.

Mutual fund dividends

Mutual funds differ from bank accounts in another way. A bank account produces only one kind of income: interest income. Mutual funds can make many different kinds of investments, so they can produce different kinds of income:

• They may invest in stocks or other investments that are later sold at a higher value, producing capital gain. When a mutual fund dividend includes long-term capital gain, you pay a lower rate of tax than you would if you received ordinary income.
• Mutual funds can also receive qualified dividends that are taxed at a lower rate than ordinary income, and pass those dividends through to you.
• Some mutual funds invest in government bonds. Mutual fund dividends that include interest from government bonds may qualify for tax benefits: municipal bonds produce interest that’s exempt from federal income tax, and interest on debt obligations of the United States is exempt from state and local income tax.

Overall these rules are quite favorable because they allow you to claim many of the same tax benefits that would be available if you personally made the same investments the managers chose for the mutual fund. But the tax reporting for mutual fund dividends is more complicated than reporting for interest on a bank account or dividends you receive when holding shares of stock.

Selling mutual fund shares

You’re selling shares whenever you withdraw from a mutual fund or move your money from one fund to another, even within the same family. The sale can produce gain or loss depending on the basis of those shares, which is generally based on their original cost. The tax rules offer two methods for determining your basis, one that looks at how much you paid for each individual lot of shares, and another that uses the average cost for all shares you own in that mutual fund.

Special rules

There are some special rules for gains and losses when you sell mutual fund shares. The sales load deferral rule may apply if you’re allowed to buy shares at a reduced sales load when switching out of another fund you held 90 days or less. You may also face special treatment when selling shares you’ve held six months or less, if you received a capital gain distribution or exempt interest dividend during that period.