Mutual Funds - Dollar Cost Averaging

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

With dollar cost averaging, an individual invests the same flat dollar amount in the same securities at regular intervals over a period of time, regardless of whether the price of the securities is rising or falling.

If the price of the securities rises, the investor cannot purchase as many units of those securities for the same flat dollar amount. However, the value of the investment as a whole will have risen. And if the price of the securities later falls, the fewer units purchased at the higher price will not drag down the total return on the investment as much as if a large lump sum had been invested at the higher price.

If the price falls, the value of the investment also falls, but the investor is able to purchase more units of those securities. If the price of the units later rises, the larger number of units purchased at the lower price will more quickly offset the loss in value caused by the earlier decline.

The table below illustrates how dollar cost averaging works. The example involves investing $1,000 on the first day of every quarter for 10 quarters. The table assumes that the security first rises, then falls significantly in price, then recovers and climbs a little past the price at which it was originally purchased. This example was created for the purpose of demonstrating only how the principle of dollar cost averaging works. In an actual case, price changes would not be so even, nor would they necessarily follow the pattern shown.

Quarter	Amount Invested	Unit Price	Units Purchased	Total Units Owned	Total Invested	Total Value
1	$1,000	$20	50	50	$1,000	$1,000
2	1,000	25	40	90	2,000	2,250
3	1,000	30	33.33	123.33	3,000	3,700
4	1,000	25	40	163.33	4,000	4,083
5	1,000	20	50	213.33	5,000	4,267
6	1,000	15	66.67	280	6,000	4,200
7	1,000	10	100	380	7,000	3,800
8	1,000	15	66.67	446.67	8,000	6,700
9	1,000	20	50	496.67	9,000	9,933
10	1,000	25	40	536.67	10,000	13,417

Investors who intend to make regular purchases of mutual fund shares may buy into an accumulation plan.

One type is the voluntary or level charge plan. Under this plan, the investor is not bound to make any specified number of payments into the plan, but the investor does indicate an intention to make regular purchases. Even though the investor is not legally bound, a voluntary accumulation plan may have some requirements, such as a minimum number of purchases per year or a minimum annual investment amount. Usually, any such minimums are set quite low, but the investor should be aware of them, and decide whether an open account might be more suitable.

Another type of accumulation plan is the contractual or periodic payment plan. Unlike the voluntary plan, this arrangement sets a definite investment goal of a fixed number of dollars to be invested at specified intervals over a fixed period of time--usually 10 years. The term "contractual" is somewhat misleading because it is actually a one-sided contract. The mutual fund is bound by its conditions, but the investor may terminate the plan if desired.

Contractual plans differ from other mutual funds in that the investor does not directly purchase shares of the mutual fund. Rather, the investor purchases shares in a contractual plan company which itself owns shares
of one specific mutual fund.

Many mutual funds allow shareholders to reinvest their returns in new shares of the fund rather than receive them in cash. This option might be available for dividends, capital gains, or both. Sometimes, if the investor chooses to reinvest dividends, capital gains must also be reinvested or vice versa. Plans vary.

In some cases, dividends may be reinvested at net asset value per share, with no sales charge. Other funds might require that the usual sales charge be applied each time a dividend is reinvested.

Once investors have accumulated a substantial investment in a mutual fund, they may want to receive part of that investment as regular income. Some mutual funds will establish a withdrawal plan which allows for periodic payouts to the investor. Generally there will be a minimum amount that must be accumulated before withdrawals may begin. The amount of withdrawals may vary, but a general guideline is no more than 6% of the total accumulation per year.

Withdrawals should come from dividends and capital gains distributions when they are adequate. If the payout is too high, however, fund shares may have to be liquidated to meet the payments, or the investor may elect to reduce the amount of each withdrawal. Share liquidation should be avoided unless the investor wants to deplete the account.

The returns earned on mutual fund shares come from two sources: dividends and capital gains distributions. Most dividends are taxable as ordinary income; however, certain investments result in tax-exempt interest as described below. Some dividends and capital gains are not distributed to the taxpayer, but instead, are reinvested in the fund. Even these undistributed returns are taxed for the year in which they would have been received had they been distributed.

Mutual fund dividends that are taxed as ordinary income to the shareholder are derived from the fund's net investment income. This is income the fund receives as dividends and interest payments from the securities in the fund's portfolio. The mutual fund must inform the taxpayer that these dividends should be shown as dividend income on the tax return and are taxable as any other ordinary income.

If a mutual fund invests in whole or in part in securities that are exempt from federal income taxation, the shareholder's dividends are not taxed on the portion that includes this exemption. The mutual fund will notify the shareholder of the amount of dividends exempt from federal taxes.

When a mutual fund sells securities from the portfolio for more than they cost originally, the profit is called a capital gain. When the profits are then passed on to the mutual fund shareholders, the fund has made a distribution which is taxable to the shareholder.

Short-term capital gains are distributed as dividends and taxed as ordinary income. Therefore, capital gains distributions from mutual funds are always long-term capital gains. Shareholders can treat them as long-term capital gains--using them to offset capital losses and having them taxed at the capital gains tax rate--regardless of how long they have held their shares.

Dividends or capital gains may be reinvested in the mutual fund rather than distributed to the shareholders. A mutual fund might declare a dividend that is paid, not in cash, but in the form of additional portfolio securities. An undistributed dividend of this type is still treated as ordinary dividend income in the year it is credited to the shareholder's account. The investment company notifies the shareholder of the undistributed dividend payment for tax purposes.

Capital gains also might be declared for the shareholder's benefit, but not distributed. Again, the gain is considered to have been received by the shareholder for tax purposes. However, because a mutual fund is required by law to pay federal income tax on undistributed capital gains, shareholders receive a credit for the same tax on the return where they report the capital gain.

Occasionally, a mutual fund may make another type of distribution called a return of capital. This distribution does not come from income or earnings. It might occur, for example, if the fund is liquidating or if the fund sells real estate it owns. A return of capital is taxable to the shareholder only if it exceeds the total amount the shareholder has invested in the fund. If there is a gain, it is a capital gain subject to offset by capital losses.

When a shareholder either redeems shares with the mutual fund or otherwise sells or exchanges them, a gain or loss generally results. For tax purposes, these will be treated as capital gains or losses that may be offset against each other.