Investing in a mutual fund is a good way to get immediate diversification of your investment portfolio. The mutual fund owns a variety of stocks, bonds or other securities based on its investment objective, and every share of the mutual fund represents equal ownership in each of the securities held by the fund. Some mutual funds let you reinvest your capital gains and dividends into additional shares. There are pros and cons to this practice.
Having your mutual fund capital gains and dividends automatically reinvested is a convenient way to handle these distributions. You don't even have to think about it. When a distribution is made, the money goes right back into your mutual fund, providing the mutual fund equivalent of compound interest on your savings account. The earnings from your mutual fund are now working to earn additional dividends and capital gains, and you don't have to lift a finger.
Some mutual funds charge a commission, or load, when you buy shares of the fund. If you elect to have your capital gains or dividends automatically reinvested back into the fund, these funds will frequently waive the sales charge on those purchases. This allows more of your money to go to work for you.
The IRS considers most mutual fund distributions to be taxable income in the year the distribution is made. That includes any portion of the distribution attributed as capital gains or dividends. You must pay income taxes on these distributions regardless of whether you receive them in cash or have them reinvested in additional mutual fund shares. You can defer these taxes if you hold your mutual fund in a qualified retirement plan, such as an IRA or 401(k).
If you are happy with your mutual fund's performance and don't need the income provided by capital gains or dividends, having those distributions automatically reinvested into additional shares makes sense. Each reinvestment creates a new basis for the additional shares purchased, so you'll want to hang on to your quarterly statements for tax accounting when you decide to sell your mutual fund shares. Mutual funds are not guaranteed investments and they are not insured by the FDIC or any other federal agency. Your investment could decrease in value and you might lose money.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.