Mutual funds generate earnings from two sources: dividends and capital gains. A mutual fund is a pass-through investment, which means that the dividends and interest it receives from stocks and bonds are "passed through" to the fund's shareholders.
Similarly, when a mutual fund sells some of its portfolio holdings, it passes along a pro rata share of the capital gains and losses realized on their sale. That means if you own 1 percent of a fund's shares, you receive 1 percent of the capital gains and losses that the fund distributes.
Capital gains are created in one of two ways: If the fund doesn't have enough cash on hand, it sells securities to redeem the shares of departing shareholders. On the other hand, the fund may decide to sell securities simply to lock in profits and boost its investment performance. In either case, you receive a proportional share of those capital gains and losses.
Before you buy into a fund, you may want to ask the fund when it plans to make its next distribution. If the fund is poised to distribute large gains, you may want to purchase shares after it makes the distribution. That way, you won't be unfairly saddled with capital gains (and capital gains taxes) as a brand-new shareholder.
Capital gains earned on the sale of mutual fund shares are taxed at a capital gains tax rate that is lower than the ordinary income tax rate if you've owned the shares for more than one year. If you own the shares for one year or less, the amount of capital gains is taxed as ordinary income.
You can minimize capital gains distributions by avoiding funds that have frequently "churn" their fund holdings. A fund's measure of how often it buys and sells its holdings is the portfolio turnover ratio. A ratio of 50% means that the fund sells half of its portfolio, on average, once a year. A fund with a 50% turnover ratio is more likely to generate more capital gains than a fund that has, say, a 25% turnover ratio.
Keeping track of your basis -- the cost you pay to buy shares -- is particularly challenging if you participate in a reinvestment plan. When you sell some of your shares, which shares do you identify for selling: Those you paid $10 for a year ago or those you paid $12 for last month?
To calculate your capital gain or loss, you use either the cost basis or average basis and subtract it from the sale price of your shares. For example, if you sell those $12 shares for $15 a share, your capital gain is $3 a share. However, if you decide that you sold the $10 shares instead, your capital gain would be $5 a share. The IRS explains how to calculate your basis on mutual fund shares in IRS Pub. 564.
The two methods of determining the cost basis are the specific-identification and first-in first-out methods. The two methods of determining the average basis are the single- and double-category methods. See Pub. 564 for more information.