Open-End Mutual Funds: Purchases, Reinvestments, Redemptions, and Taxes
Mutual funds are a great way to diversify your portfolio for very little money. Although most mutual funds have a required minimum, it is considerably less than the amount it would take you to diversify your portfolio by buying the individual securities. You also benefit from the investment expertise of the fund's investment adviser. However, there are special considerations in buying and selling mutual funds, and paying taxes on the income.
The shares of open-end mutual funds are offered continuously, and the price per share is equal to the fund's net asset value (NAV) per share plus any sales charge (aka load), which cannot exceed 8.5%.
The net asset value is the value of the portfolio minus all liabilities of the fund.
The NAV is calculated once each day, using the prices at the close of the New York Stock Exchange (NYSE) at 4 p.m. Eastern Standard Time. If an order for shares is received before 4 p.m., then the price will be determined by the NAV calculated at the NYSE closing. If an order is received after 4 p.m., then the price will be determined by the NAV calculation on the following business day. This is known as the forward pricing rule.
The public offering price can be calculated by dividing the NAV per share by 100% minus the sales charge percentage.
|Public Offering Price||=||NAV per Share|
100% - Sales Charge %
Example: Calculating Public Offering price from NAV and Sales Load
- NAV = $10 per share.
- Sales Charge = 8.5%, the maximum allowable by law.
|Public Offering Price||=||$10|
100% - 8.5%
|=||$10.93 per Share|
One of the main benefits of a mutual fund is the ability to automatically reinvest income or capital gains, and to be able to buy fractional shares of the fund.
The prospectus will list the 3 available options in what is called the reinvestment privilege:
- to reinvest both dividends and capital gains in additional shares of the fund;
- to receive dividends as cash and reinvest the capital gains in additional shares;
- or to receive both dividends and capital gains as cash — no reinvestment.
Note, however, that taxes must be paid on all income earned during the year, even if that income is automatically reinvested.
All the money can be reinvested because mutual funds allow the purchase of fractional shares, and there is no sales charge for reinvestment. For example, if you reinvest $100 for shares with a NAV per share of $9.50, then you can purchase $100/$9.50 = 10.53 additional shares.
Redemption of Shares
Unlike most securities, when a shareholder of a mutual fund wants to sell his shares, he sells them back to the company. The company, required by law, must redeem the shares by buying them back — redemption. The shareholder must convey his share certificates to the company with a written request for redemption. The fund must pay the seller within 7 days of receiving the required documents.
The amount of the redemption is determined by the next NAV calculation following the receipt of the required documents.
Because mutual fund investors must pay the NAV plus any load, but get only NAV when they redeem their shares, the NAV plus load is sometimes known — from the fund's point of view — as the ask price and the NAV that is paid at redemption is known is the bid price of the mutual fund.
Systematic Withdrawal Plan
Most funds also have a systematic withdrawal plan for the convenience of investors who want to withdraw a specific amount periodically. What is not taken out continues to earn income as it is reinvested. How long the money will last depends on the account balance, how much is being withdrawn, and how fast the fund is growing. Although the fixed, regular payments are like an annuity, there is no guarantee that the income will last.
Mutual Fund Returns
Mutual funds earn investment income, which is income derived from the dividends and interest from the securities in its portfolio, and from the net profit from the sale of short-term securities. The total amount of investment income is the gross investment income, from which the fund subtracts its operating expenses. What remains is net investment income, which is distributed as dividends to shareholders or reinvested, usually quarterly.
Net Investment Income = Gross Investment Income – Operating Expenses
Most mutual funds also sell securities during the course of a year, for either a capital gain or loss. All capital losses for the year are offset against capital gains. If the capital gains is greater, then the fund will have a net realized capital gains that is distributed annually as a capital gains distribution, or reinvested, if the investor so chooses.
A shareholder can also earn a profit when he redeems his shares, if the redemption price exceeds the purchase price. Thus, the shareholder can potentially receive investment income, capital gains income, and income from the final disposition of his shares, which are all taxable.
As an investment company, the law requires that mutual fund companies distribute at least 90% of their income to shareholders to avoid a corporate tax on the mutual fund. The result is that only the shareholders pay the taxes on the net income and capital gains of the fund.
Unless the mutual fund is held in a tax-exempt account, such as a 401(k) or an IRA, shareholders have to pay the taxes on all income earned, whether it is reinvested or distributed. The fund will send each shareholder a Form 1099-DIV listing dividend and capital gains income for the year.
The dividend, which is taxed as ordinary income, comes from the dividend and interest payments from the fund's portfolio of securities, and from the net profit of selling securities held for less than 1 year. The capital gains of a fund are the result of the fund selling securities, held for 1 year or longer, for a net profit. Note that whether the net profit from securities sales is considered long-term or short-term depends on how long the mutual fund has owned it — not on how long the shareholder has held shares of the mutual fund. That means that shareholders that have held the mutual fund shares for less than a year may still have long-term capital gains income. However, if the shareholder redeems her shares for a profit, then the gain on the redemption will be a long-term capital gain only if she held the shares for 1 year or longer.
Some mutual funds claim to have a tax efficiency, which is accomplished by buying securities that pay no income or only enough to pay operating expenses, and by infrequent selling. This leads to fewer taxable events being passed onto shareholders. Such a fund must be a growth fund invested mainly in stocks.
One way to gauge tax efficiency is by looking at the mutual fund's turnover rate, which is the rate the fund buys or sells securities. The turnover rate percentage is equal to the lesser of the total sale of securities or purchases divided by the fund's average monthly assets for the year.
|Turnover Rate %||=||Lesser of Security Sales or Purchases |
Average Monthly Assets
For instance, if the fund has a turnover rate of 50%, then it holds its securities for an average of 2 years. A 100% rate would indicate an average holding period of 1 year. A higher turnover rate will lead to higher taxes for the investors in the fund, unless the fund is suffering losses.
The fund's prospectus has a section listing the after-tax returns of the fund for the previous year, 5 years, and 10 years, for both a pre-liquidation return and a post-liquidation return. The pre-liquidation return assumes that the investor held the shares for the entire period. The post-liquidation return is based on the income received during the entire period and the gain on redemption at the end of the period. The tax rate used in the calculations is the rate someone in the highest tax bracket must pay. If you are in a lower bracket, or the fund is in a tax-exempt account, then the return will be higher.