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TAXATION OF MUTUAL FUNDS

Mutual funds make three types of distributions - ordinary dividends and capital gain distributions, which are paid out of the income of the fund, and, on occasion, a "return of capital", which is paid out of "principal".

Ordinary dividends and short-term capital gain distributions are generally taxed as "ordinary income" at the taxpayer's normal tax rate. However, since 2003 some of these dividends are considered to be "qualified dividends" and taxed at the lower capital gain rates of 5% or 15%. Ordinary dividends that represent earnings from fund investments in tax-free mutual bonds are exempt from federal taxation, but may be fully or partially taxed on your state income tax return.

Long-term capital gain distributions are treated the same as long-term capital gains from the sale or exchange of investments. They are reported on Schedule D and taxed at the appropriate lower capital gains rate.

A distribution classified as "return of capital" is, in effect, giving back to you part of the purchase price of the fund shares, and is not taxable. It will, however, reduce your cost basis in the fund.

Ordinary dividends from a mutual fund that represent earnings from fund investments in a direct obligation of the United States government, while fully taxable on your federal return, may be exempt from state income taxes. The mutual fund will usually send you a statement or notice in January that indicates what % of ordinary dividends are from US government obligations.

Distributions from mutual funds are taxable even if you do not actually receive the cash in your hands. Many investors elect to have some or all of the distributions reinvested in the fund. Reinvested distributions are treated as if you received a cash distribution from the fund and then turned around and used the cash to purchase additional shares in the fund, and, unless they represent a "return of capital", are fully taxable.

Since reinvested dividends are actually additional purchases of fund shares, they are added to the cost basis of your investment and will decrease your taxable gain, or increase your deductible loss, when you sell the fund.

Let's say you invested $1,000.00 in the ABC Mutual Fund in 2001, and elected to have all distributions reinvested. Between 2001 and 2007 you received $700.00 in taxable distributions, which were reinvested in the fund. At the end of 2007 you sell all your shares in the fund for $1,200.00. You have a $500.00 long-term capital loss ($1,000.00

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