Often when tax season nears, mutual fund investors become confused. Why do we have to pay taxes on a fund that had a losing year? By law, mutual funds must declare distributions each year. These distributions represent a profit the fund made when selling securities. Every year, usually in December, the fund will pay out these gains to the shareholders in the form of income dividends and/ or capital gains.

Even in years with negative returns, mutual funds can, and must, pay out distributions. Capital gains are calculated by taking the price you sold the security for and subtracting your purchase price (cost basis). It doesn't matter if the securities that the fund held were doing poorly, all that matters is that the fund sold the security at a profit and must now pay out the profits in the form of a distribution, which is a taxable event for the shareholder.

To better understand how this could happen, imagine your fund bought a security in 1997 for $15 a share. At the start of 2000, the security was worth a total of $30 a share, but the fund ended up selling the security for only $25 a share. This is a loss for the year, but an overall profit of $10 a share. Another possibility would be for the fund to sell the security for $35 a share, which is a gain even for the most current year, but the rest of the funds holdings went sour and created a losing year for the fund. This fund would still be forced to pay out capital gains on the security that they sold.

What if the fund has capital losses?

It is possible that the fund did not make a profit off selling its securities. In the case of capital losses, the fund would not pay out a distribution (although they could pay income distributions). The fund would apply the loss to future capital gains.

What if I signed up to automatically reinvest the dividends?

This is still considered a taxable event. Reinvested dividends are treated as cash payments.

What if I bought the fund one day before the distribution was declared?

Sorry, but you are out of luck. It doesn't matter whether you held the fund for one day or for 10 years, you are still stuck with paying taxes on the distribution. This is why advisers usually recommend that you never buy a fund right before it pays a distribution. The distribution does lower the net asset value (NAV), allowing you to deduct it when you sell the fund, but paying the taxes sooner rather than later prevents you from gaining investment income on the amount that is taxed.

What if my mutual fund is in an IRA or 401k plan?

If you find yourself in this situation, there is no need to worry. Taxes do not affect a non-taxable account. Uncle Sam will have to wait until you start taking money out of these accounts (the Roth IRA is an exception).