How Does a Fund's Investment Strategy Affect My Taxes?
Several factors generally affect a fund's likelihood of passing along a taxable distribution: the kinds of securities the fund invests in, the portfolio's turnover rate and the fund's investment policies.
Money market funds1 pay ordinary dividends from the income produced by their portfolio investments. Because these funds own only short-term securities, which are normally held to maturity, they do not ordinarily generate capital gains or losses. Whether the income dividends they pay are taxable depends on the nature of the fund. Money market funds that invest in municipal securities produce income that is generally not subject to federal income tax and, in a state-specific fund, may also be exempt from state and local taxes.
Bond funds typically produce higher levels of income dividends (which again may be taxable in whole or in part, depending on the nature of the fund). However, because the prices of bonds fluctuate in response to changing interest rates as well as credit risk, it is possible to have taxable capital gain distributions from bond funds, even tax-exempt bond funds.
Stock funds may pass along ordinary income from dividends paid by stocks held in the fund as well as from capital gains from the sale of stocks. Because stock prices fluctuate considerably, you are generally more likely to realize a larger capital gain or loss when selling shares of a stock mutual fund than when selling shares of bond funds. To help gauge the potential tax impact, know your stock fund's objective to learn whether it emphasizes older, larger, well-established companies, or newer, smaller companies just starting out (the stocks of the latter are normally more volatile). Also determine whether it concentrates on value stocks or growth stocks; growth stocks tend to be more volatile. A mutual fund's investment strategy can also affect the taxes of shareholders in the fund. Capital gain distributions result from the profitable sale of securities by the fund. Therefore, frequent selling by a fund makes the fund more likely to produce annual taxable distributions than a fund that follows a strategy of "buy-and-hold."
Types of Mutual Funds and Their Potential Taxable Distributions
|Type of Fund||Potential for Federal Taxable Income||Potential for Capital Gains|
|Taxable money market||High||Very Low|
|Tax-exempt money market||Very Low||Very Low|
|Tax-exempt bond||Very Low||Low|
|Balanced (stocks and bonds)||Medium to High||Medium to High|
|Growth and income stock||Medium to High||Medium to High|
1. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation, or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. As a measure of current income, seven-day yield is more reflective of the fund's income generating ability than total return.
The information set forth here is general in nature and does not constitute tax advice. Specific questions should be discussed with your tax advisor.