Mutual funds make periodic payments to shareholders representing a share of the interest, dividend, and capital-gain income earned by the fund. These payments are called “distributions.” If you’re not careful in accounting for these distributions, you could pay more federal and state income taxes than necessary when your fund shares eventually are sold.

(*This article applies only to those investments held in a taxable account*. If your funds are held in an IRA or other retirement account, fund distributions won’t affect your tax situation. Feel free to skip to the final paragraph regarding how brokers display gains/losses.)

A capital gain is the profit that results when you sell an investment for more than you paid for it. Many fund investors assume that the way to calculate the amount of their capital gain is to always subtract the amount they paid for their shares (their cost “basis”) from the proceeds they received when selling them. This is only true in the simplest instance — where you bought all your shares at the same time, received no distributions while you owned them, and sold them all at the same time.

However, if you receive distributions, acquire your shares over time (for example, through dollar-cost-averaging or reinvesting your dividends), or sell only part of your holdings, there is more work to be done. Let’s look at the most common situations.

A more complicated variation of the averaging method allows you to separate your shares into two groups based on whether they’ve been held shorter or longer than one year. You then specifically designate which group you are selling from when each sale is made. Most investors won’t want to bother with the hassle of this “Average- Cost, Double-Category” method, but in some cases the extra effort may pay off in reduced capital-gains taxes.

While you can switch back and forth between the default (FIFO) method and specifically identifying shares to sell, if at any point you choose to use an average-price method, you must continue to use that averaging method for all future sales of that same fund.

**When you***receive*a distribution.

Keep in mind:*you aren’t really gaining anything when you receive a distribution because the amount of the distribution is deducted from the value of your shares.*In fact, you may be signing up for an unnecessary tax bite.

For example, assume you buy 100 fund shares at $8.00 each. Your total cost is $800. The value grows to $12.00 per share, and your investment becomes worth $1,200 (100 shares multiplied by $12.00 each). If a $1.00 per share dividend distribution is declared, you will receive a check for $100 (100 shares multiplied by $1.00). However, on the ex-dividend date, the value of your shares immediately drops to $11.00 because $1.00 per share has been taken out of the fund’s assets to be mailed to shareholders. You haven’t gained; you still have $1,200 in value — $1,100 in fund shares (100 shares multiplied by $11.00) and $100 cash. The fund has merely “robbed Peter to pay Paul.”

The tax consequences work like this. If you had sold your shares*before*the fund distribution, you would have a $400 capital gain ($1,200 proceeds minus $800 cost). If you sell your shares*after*the distribution, you would have a $300 capital gain ($1,100 proceeds minus $800 cost)*plus*$100 in dividend income; thus, you still have total taxable income of $400. Selling after the distribution didn’t change the amount of your profit; it only changed the tax*nature*of your profit.

**When you***reinvest*your distributions.

If you have authorized your broker to reinvest your fund distributions in more shares, you must be careful to avoid double taxation. When calculating your tax liability, you should add the cost of the additional shares purchased with your distribution proceeds to the amount originally invested in the fund. This will raise your tax “basis” in the fund shares you’ve acquired. In this way, you’ll avoid being taxed twice — initially on the distribution and again later as a capital gain when the fund shares are sold.

For example, let’s take our previous example and make a change: Instead of receiving the $100 distribution in cash, you instruct your fund to reinvest it in more shares. On the ex-dividend date, the value of the fund dropped to $11.00 per share as before. At that price, the $100 would purchase an additional 9.09 shares, bringing your total shares to 109.09.*The $100 distribution must still be reported on that year’s federal 1040, and taxes must be paid.*Later, you sell all of your shares for $11.00 each, which brings in proceeds of $1,200 (109.09 shares multiplied by $11.00 per share). Will you be taxed on your entire $400 gain? No. The total cost of the shares (for capital-gains purposes) is the initial $800 paid*plus the $100 reinvested distribution on which tax has already been paid,*making a total cost of $900. Thus, the taxable capital gain from the $1,200 proceeds received the following year is only $300 rather than $400.

**When you dollar-cost-average.**

If you add to your fund holdings through frequent new purchases, you should be especially careful to keep records of the dates, amounts invested, and number of shares purchased. That’s because you will later need this detailed information in order to compute any capital gains when your shares are eventually sold. This is all the more true if you later sell part (rather than all) of your shares.

Unless you say otherwise, the IRS assumes that you sell your shares in the same order as you bought them. This is known as FIFO accounting (First-In, First-Out). If your early purchases were at higher levels, this method will give you tax losses; if your early purchases were at lower levels, this method will create taxable gains. You have other options:- Calculate the
*average*price paid for*all*the shares sold. Divide the total dollars invested (including any distributions reinvested) by the number of shares you owned. This could either raise or lower your taxes depending on how the other alternatives work out.

- Send the fund written instructions saying you are selling the
*specific*shares bought on such-and-such a day at such-and-such a price. This gives you the most flexibility for managing your tax liability.

- Calculate the

As you can see, dealing with mutual-fund distributions in a taxable account can get fairly involved, particularly when you have distributions reinvested automatically. Because of this, we typically advise readers to *not* reinvest their fund distributions within taxable accounts. While this does require the owner to occasionally reinvest any cash received from distributions, it can greatly simplify tax reporting when a fund is sold.

**Distributions affect how gains/losses are displayed by some brokers**

On a related note, mutual-fund distributions can have a significant impact on the gains or losses some brokers display for the holdings in their client accounts. While gain/loss calculation methods vary from broker to broker, the results can be terribly misleading when not properly adjusted for distributions. To get a true picture of your actual gain/loss, you’d need to add each distribution amount back to the current price of the fund, *then* calculate the gain/loss between that adjusted price and the original purchase price.

Not including those distribution amounts in the calculation, which some brokers do not, can lead to wildly inaccurate results. Because of this, we suggest ignoring the gain/loss calculations shown for the holdings in your brokerage account unless you’ve specifically verified your broker accounts for fund distributions correctly.