The law requires mutual funds to distribute net gains from security sales to their shareholders. During the fourth quarter, fund managers calculate their net gains for the year and distribute it through dividends to shareholders. The shareholders will pay federal and state income taxes at the special capital gain rates on these distributions. After a distribution is made, the value of the fund's shares drops.
If you buy shares of a fund for $10,000 on Dec. 1 and the fund issues a $1,000 capital gain dividend on Dec. 15, your shares will be worth $9,000 on Dec. 16. You had no real gain or income, but you must pay tax on the $1,000 distribution.
If you want to purchase fund shares during the final months of the year, wait until after the distribution is issued and the fund's value drops. It might be too late for you to address your mutual fund dividends this year, but it's something to keep in mind for next year.
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