There are two ways to make money on mutual fund holdings: capital appreciation and distributions.

Capital Appreciation

One way to earn money on mutual fund shares is to purchase shares and hold them for an extended period of time. Then, when the market value of the shares increases, you can sell the shares and collect capital gains. Capital gains are generally the preferred type of earnings because capital gains are not taxed until you sell your mutual fund shares, and you decide when to sell those shares. In addition, capital gains are taxed at 15 percent by the federal government whereas ordinary income may be taxed at a rate of up to 35 percent.

Distributions

Distributions are the second way that you can make money on mutual funds. There are five main types of distributions: long-term capital gains, qualified stock dividends, ordinary (non-qualified) dividends, short-term capital gains, and bond dividends and interest.

Long-term Capital Gains: Long-term capital gains are earnings on assets the fund has owned for 366 days or more. In 2010, long-term capital gains are taxed at a federal rate of 15 percent if your marginal tax rate is 25% or higher, or 0% if your federal marginal tax rate is 15% or less.

Qualified Stock Dividends: Qualified dividends are stock dividends which have been held for a certain number of days within a specific period of time. A qualified dividend is a dividend paid by a U.S. corporation and you held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (see Learning Tool 32: Taxes on Securities Earnings Including Qualified Dividends). In 2010, qualified stock dividends are taxed at a federal rate of 15 percent if your marginal tax rate is 25% or higher, or 0% if your federal marginal tax rate is 15% or less.

Ordinary (or Non-Qualified) Stock Dividends: Ordinary stock dividends are cash earnings paid to investors by stock companies who have not held the stocks for the necessary amount of time. These dividends are taxed as ordinary income at both the federal and state levels.

Short-term Capital Gains: Short-term capital gains are earnings on assets you owned for less than 366 days. Short-term capital gains are taxed at your marginal tax rate, which can be up to 35 percent for federal taxes and 10 percent for state taxes.

Bond Dividends and Interest: Bond dividends and interest are distributions from bonds and bond mutual funds. These earnings are taxed at your marginal tax rate, which may be as high as 35 percent for federal taxes and as high as 10 percent for state taxes.

Distributions are a less attractive type of earnings than capital gains because you do not have control over the taxes associated with distributions. Even if you do not sell any mutual fund shares, you must still pay taxes on your mutual fund’s annual distributions.

The key to making money on mutual fund holdings is to invest in funds with high after-tax returns. The higher the after-tax returns on a fund, the more quickly you will be able to achieve your personal and financial goals.