Dividends and Capital Gains
Mutual funds can earn income within the fund in the form of dividends or capital gains. Dividends are earned when a dividend is paid out from a security held by the fund. Capital gains are paid out when a fund sells securities that have increased in value. The investment company may distribute income from dividends to shareholders whenever it sees fit, but it can distribute income from capital gains no more than once a year. The company must send out a letter that clearly delineates which distributions are capital gains and which are dividends. The shareholder will be responsible for paying the appropriate taxes on both types of distributions.
If an investor sells or exchanges mutual fund shares for a profit, she has to pay a tax on the gain. If she holds the shares for one year or less, she will pay at the