Why do the mutual funds distribute capital gains?

When a mutual fund realizes more gains than losses, mutual funds are generally required by law to distribute the net gains to shareholders by calendar year end. These distributions, which typically occur quarterly, semi-annually or annually, are made in order to satisfy such requirements. It is important to note that these distributions are taxable to shareholders, unless the mutual funds are held in a 401(k) plan, IRA, 403(b) account or other tax deferred account Investors in tax deferred products will not have tax consequences as a result of these distributions. Also, distributions are specifically exempt from taxes such as income from municipal bond funds being exempt from Federal taxes.

What is the difference between short-term and long-term capital gains?

Short-term capital gains: These gains result from the sale of an investment held less than a year. A distribution of short-term gains by a mutual fund is taxed as ordinary income. Long-term capital gains: These gains result from the sale of an investment held more than a year. A distribution of long-term gains by a mutual fund is taxed at the investor's capital gains tax rate.

When are taxes paid on capital gains distributions?

Investors are required to include these amounts on their federal income tax return for the year when they are received.

If distributions are reinvested, are they still subject to taxes?

Yes, it is the shareholder's responsibility to pay taxes on the income and gains distributed by a mutual fund even if a shareholder decides to reinvest his distribution into the mutual fund for more shares.

Why does a mutual fund's NAV drop when a distribution is paid?

When profits from sales of securities exceed losses, they accumulate and contribute to the rise of the net asset value (NAV) of the fund. Since a portion of the NAV is being deducted and distributed to the shareholders, the NAV will drop by the distribution amount. For example, a fund's shares sell at an NAV of $10. If sales of the fund's securities have realized a profit of $2 a share during the year, a capital gain distribution of $2 will be deducted from the NAV on a specified date and on that date the fund share price will decline to $8. This drop in NAV does not reflect a loss since the portion deducted from NAV is passed through to shareholders. Distributions do not impact a mutual fund's total return as they are taken into account as part of a fund performance. Please keep in mind that the NAV will also reflect market activity.

When is a Form 1099 sent to shareholders?

A Form 1099-DIV is sent to shareholders by investment fund companies to provide a record of all taxable capital gains and dividends paid, including those that have been re-invested in a given taxation year. Tax Form 1099-B will also be sent if you have redeemed shares from your BlackRock mutual fund. Form 1099-INT is sent to you if you have receive dividend distributions on municipal bond funds.

In the United States, mutual funds most often are registered with the Securities and Exchange Commission, overseen by a board of directors (or trustees if organized as a trust rather than a corporation or partnership) and managed by a registered investment advisor. Mutual funds are not taxed on their income and profits if they comply with certain strict requirements under the U.S. Internal Revenue Code. Mutual funds have both advantages and disadvantages compared to direct investing in individual securities. They have a long history in the United States. Today they play an important role in household finances and retirement planning. U.S. registered mutual funds can be characterized generally in 1 of 3 ways: open-end, unit investment trust, and closed-end. The most common type, the open-end fund, holds itself out to investors it will buy back shares from investors wanting to sell them back to the fund on any regular business day at the price next determined (usually once at the end of the day). Exchange-traded funds (or "ETFs" for short) are open-end funds or unit investment trusts that trade on an exchange. Open-end funds are most common, but exchange-traded funds have been gaining in popularity. Closed end funds were described earlier. Mutual funds are often classified by their principal investments relative to their investment objective. The four largest categories of funds are money market funds, bond or fixed income funds, stock or equity funds and hybrid funds. Funds may also be categorized as index or actively managed. Investors in a mutual fund incur the funds expenses, which reduce the fund's returns/performance. Many parties are interested in the level of these expenses - investors, boards, investment advisors and regulators. A single mutual fund may give investors a choice of different combinations of expenses (and potentially commissions or loads) by offering several different types of share classes. Mutual funds are not taxed on their income and profits as long as they comply with strict requirements established in the U.S. Internal Revenue Code. Specifically, they must diversify their investments, limit ownership of voting securities, distribute a high percentage of their income and net capital gains [2] to their investors annually, and earn most of the income by investing in securities and currencies. Mutual funds pass taxable income on to their investors by paying dividends and capital gains, if any. The type of income they earn is unchanged as it passes through to the shareholders. For example, mutual fund distributions of dividend income are reported as dividend income by the investor. There is an exception: net losses incurred by a mutual fund are not distributed or passed through to fund investors but remain in the fund to be able to offset future gains. Mutual funds may invest in many kinds of securities in accordance with its objective. The types of securities that a particular registered fund may invest in are set forth in the fund's prospectus, which describes the fund's investment objective, investment approach and permitted investments. The investment objective describes the type of income that the fund seeks. For example, a "capital appreciation" fund generally looks to earn most of its returns from increases in the prices of the securities it holds, rather than from dividend or interest income. The investment approach describes the criteria that the fund manager uses to select investments for the fund. A mutual fund's investment portfolio is continually monitored by the fund's portfolio manager or managers, who are employed by the fund's manager or advisor.

Mutual funds have advantages compared to direct investing in individual securities. These include: Increased diversification Daily liquidity Professional investment management Ability to participate in investments that may be available only to larger investors Service and convenience Government oversight Ease of comparison
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Mutual funds have disadvantages as well, which include : Fees Less control over timing of recognition of gains Less predictable income No opportunity to customize

TAX CONSEQUENCES
When you buy and hold an individual stock or bond, you must pay income tax each year on the dividends or interest you receive. But you wont have to pay any capital gains tax until you actually sell and unless you make a profit. Mutual funds are different. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them. And, in addition to owing taxes on any personal capital gains when you sell your shares, you may also have to pay taxes each year on the funds capital gains. Thats because the law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that cant be offset by a loss. Bear in mind that if you receive a capital gains distribution, you will likely owe taxeseven if the fund has had a negative return from the point during the year when you purchased your shares. For this reason, you should call the fund to find out when it makes distributions so you wont pay more than your fair share of taxes. Some funds post that information on their websites. SEC rules require mutual funds to disclose in their prospectuses after-tax returns. In calculating aftertax returns, mutual funds must use standardized formulas similar to the ones used to calculate beforetax average annual total returns. Youll find a funds after-tax returns in the Risk/Return Summary section of the prospectus. When comparing funds, be sure to take taxes into account.

TAX EXEMPT FUNDS If you invest in a tax-exempt fundsuch as a municipal bond fundsome or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.