Buying the dividend  or capital gain distribution and wash sales

One of the advantages of investing in a mutual fund is the ability to purchase and redeem shares on any day the market is open, although, it is important to note that there is market risk involved when investing in mutual funds, including possible loss of principal. Potential shareowners indicate the amount they wish to invest and the share price is determined after the next closing of the financial markets.

However, there are times when it may not be in your best interest to purchase shares because the fund is about to make a dividend or capital gain distribution. These shares may generate income, upon which you may have a tax liability. When this occurs, it is called buying the dividend or capital gain distribution.

Take for example two investors that are interested in shares of a stock fund investing primarily in large companies:

Investor A invests $10,000 in the fund on June 24th. Because the Net Asset Value of the shares is $50, Investor A is able to purchase 200 shares. On June 25th, the fund makes a previously announced distribution of $1.50 per share, reducing the NAV to $48.50 per share. Investor A receives $300 in dividend income or capital gain that is reinvested in the fund. Investor A's original shares are now worth $9,700 ($48.50 x 200) and the reinvested dividend purchases 6.186 additional shares ($300 ÷ 48.50). Investor A now has 206.186 shares and taxable income of $300.

Investor B waited until the day after the distribution is made.  Her $10,000 purchased 206.186 shares (10,000 ÷ 48.50) but she has not received any dividend income, so there are no taxes assessed.

Of course, this example does not take into account any sales loads or expenses that may be required. The dividend example is hypothetical and is not based on any mutual fund investment currently available. It merely shows what can happen when a purchase is made immediately prior to a dividend or capital gain distribution. You should consult a tax advisor for additional information.

Another transaction that may carry tax consequences is a wash sale. This occurs when shares of a mutual fund or individual securities are sold at a loss and substantially identical replacement shares are purchased within 30 calendar days either before or after the sale. Rules set by the Internal Revenue Service prohibit shareowners from declaring a capital loss when a wash sale occurs.

The initial sale may have been made in order to declare a short- or long-term capital loss for tax purposes. A capital loss can ordinarily be used to offset a capital gain on your personal income taxes, lowering the amount you may owe for the year. However, purchasing substantially identical shares within either 30 calendar days before or after the sale will prevent you from declaring a loss on your tax return.

However, the situation may not be as bas as it seems. That's because the disallowed loss is added to the cost basis of the replacement shares. In other words, if you had originally paid $20 for the individual shares, sold them for $10 (a loss of $10 per share), and purchased replacement shares for $11, your cost basis for the new shares is now $21 (the $11 purchase price plus the $10 loss). In this way, depending on your tax situation, the capital loss on the initial sale may eventually be realized when the replacement shares are sold.

Your holding period for the replacement shares is also changed to include the amount of time you held the original shares. While that may not seem like such a problem, it can make a difference in determining a long- or short-term capital loss or gain when you decide to sell the shares. See your tax advisor for additional information.

Net Asset Value (NAV) is calculated by adding all of the assets of a Fund, subtracting the Fund’s liabilities, then dividing by the number of outstanding shares.  A separate NAV is calculated for each class of each Fund.  NAV is calculated at the close of each business day.

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AP2008/12/1749