Tax Advantages of Investing in Mutual Funds
When you buy and hold an individual stock or bond, you must pay income tax each year on the dividends or interest you receive. But you won't have to pay any capital gains tax until you actually sell and unless you make a profit. Mutual funds are different. When you buy and hold mutual fund shares, you will owe income tax on any ordinary dividends in the year you receive or reinvest them. And, in addition to owing taxes on any personal capital gains when you sell your shares, you may also have to pay taxes each year on the fund's capital gains. That's because the law requires mutual funds to distribute capital gains to shareholders if they sell securities for a profit that can't be offset by a loss.
Tax Exempt Funds
If you invest in a tax-exempt fund - such as a municipal bond fund - some or all of your dividends will be exempt from federal (and sometimes state and local) income tax. You will, however, owe taxes on any capital gains.
Bear in mind that if you receive a capital gains distribution, you will likely owe taxes - even if the fund has had a negative return from the point during the year when you purchased your shares. For this reason, you should call the fund to find out when it makes distributions so you won't pay more than your fair share of taxes. Some funds post that information on their websites.
SEC rules require mutual funds to disclose in their prospectuses after-tax returns. In calculating after-tax returns, mutual funds must use standardized formulas similar to the ones used to calculate before-tax average annual total returns. You'll find a fund's after-tax returns in the "Risk/Return Summary" section of the prospectus. When comparing funds, be sure to take taxes into account.
Source: http://www.sec.gov/investor/pubs/inwsmf.htm
WE HAVE PROVIDED THIS INFORMATION AS A SERVICE TO INVESTORS. IT IS NOT A LEGAL INTERPRETATION. NEITHER IS IT AN INTERPRETATION OF OR A STATEMENT ABOUT SEC POLICY. IF YOU HAVE QUESTIONS CONCERNING THE MEANING OR APPLICATION OF A PARTICULAR LAW OR RULE, PLEASE CONSULT WITH AN ATTORNEY WHO SPECIALIZES IN SECURITIES LAW.