Confused about cap gains

[Cal]

Ok - I am trying to wrap my brain around this and am humbly asking for help. Please be kind.

I buy 10 shares of a mutual fund at $50/share = $500 investment. At the end of the year, the fund distributes $50 in capital gains. The following year, when the share price reaches $75/share, I sell receiving proceeds of $750.

Which is correct:

1. I pay tax on $50 in capital gains in the first year and $200 in cap gains in the second ($750-$500-$50).

2. I pay tax on $50 in capital gains in the first year and $250 in capital gains in the second year (the prior year's capital gains are not counted).

3. Neither

I understand how this works when selling individual shares of stock, but am having problems understanding how it works for mutual funds. Up to now, all my mutual funds have been held in retirement accounts, but now I've saved enough that I want to start investing outside the tax shelter of retirement accounts.

Thanks,
Cal

 

[JWR1945]

Number 1 is correct (or, at least, it used to be).

You pay taxes on the distributed capital gains as you receive them. At the same time, those gains reduce your cost basis.

I remember owning a bond fund in a taxable account (decades ago). Every year I had to pay taxes while the value of my mutual fund kept falling. It left a bitter taste in my mouth.

Have fun.

John R.

 

[Nords]

Is that cap gain reinvested?

Cal,

You don't specify whether or not that $50 cap gain was distributed outside of the account or reinvested into the mutual fund. Of course you have to pay taxes on the cap gain distribution no matter what you do with it.

If you spent the $50 cap gain distribution instead of reinvesting it, then your cost basis in the mutual fund remains $500 and next year's sale is taxed on $250 of cap gains.

If you reinvested the $50 cap gain, your cost basis is now $550 and next year's sale is taxed on a "$200" cap gain but...

The flaw in your reinvestment numbers is that $50 reinvestment buys as much as one more share. You start the second year with 10+ shares of the fund, so when it's sold at $75 you receive more than $750. But your cost basis is still $550.

 

[Cal]

Thanks.
Many, many moons ago, I threw some money into a mutual fund. Lost my shirt and still had to pay capital gains. I vowed never to invest in mutual funds again outside of a retirement account.

Fast forward a couple of years. A little more maturity and a little more wisdom. (Yeah, right. : ) I've been reading Bernstein's books and agree that index funds would do a better job than I could at investing, so I'm ready to take the dive again.