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How Funds Can Make Money

What are the three ways to make money in mutual funds?

A chronology of share price movements and distributions

How various fund types distribute profits

Tax consequences of the three types of distributions in unsheltered accounts

Strategies considering taxation of distributions

The three ways to make money in mutual funds

Interest or dividend distributions

Internally generated capital gains

Share price gains

Chronology of share price movements and distributions

• Assume you invest $1,000 in a stock fund on January 10, 1996
• The market moves up through August 15, 1996
• The fund sells shares just before the August peak
• The fund collects dividends and interest throughout the year
• The fund makes a its only distribution on December 21, 1996
• You reinvest your distributions in new shares of stock

Date	Per share information				Number of shares you own	Total value of your holdings
	Accumulated interest and dividends	Accumulated internal capital gains	Underlying value of held securities	Total share price of fund
Jan. 9, 1996	$0.00	$0.00	9.95	$9.95	0.00	$0.00
Jan. 10, 1996	0.00	0.00	10.00	10.00	100.00	1,000.00
Jun. 30, 1996	0.50	0.00	11.50	12.00	100.00	1,200.00
Aug. 15, 1996	0.65	0.00	12.00	12.65	100.00	1,265.00
Sep. 30, 1996	0.75	1.00	9.25	11.00	100.00	1,100.00
Dec. 20, 1996	1.00	1.00	11.00	13.00	100.00	1,300.00
Dec. 21, 1996	0.00	0.00	11.00	11.00	118.18	1,300.00
Jan. 1, 1997	0.00	0.00	11.10	11.10	118.18	1,311.82

How various fund types distribute profits

Here is a rough estimate of how various fund types help you make money

Fund type	Interest or dividend distributions	Internal capital gains	Share price gain or loss
Money market	moderate	none	none
Short-term bond	moderate	low	low
Long-term bond	high	moderate	moderate
Junk bond	very high	moderate	moderate
Blue chip stock	moderate	moderate	moderate
Growth stock	low	moderate to high	high
Aggressive growth stock	low	high	moderate to high
Stock index	moderate	low	high

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Tax consequences of the three types of distributions in unsheltered accounts

Interest or dividend distributions

• taxable immediately at highest rates
• receive 1099-DIV each February
• report on Schedule B of form 1040

Internal capital gains

• taxable immediately at possibly favorable rates
• receive 1099-DIV each February
• report on schedule B and Schedule D of form 1040

Share price gains

• taxable only when sold at possibly favorable rates
• receive 1099-B by February of year after sale of shares
• report on Schedule D of form 1040

Strategies considering taxation of distributions

Defer taxation of interest and dividend distributions by sheltering long-term bond, junk bond and blue chip stock funds inside retirement accounts

If already maxed out on retirement account contributions, defer taxation on unsheltered funds by investing in growth stock index funds outside retirement accounts

If the fund is outside of a retirement account, don't invest in the fund right before the fund's distribution date

Mostly applies to stock funds

Most stock funds distribute internally generated gains and other income in December

If you invest in a fund before the distribution date, you'll pay taxes on someone else's gains

Body text copyright 1997 by David Luhman