In the first place every year each fund makes two types of payment: income and capital gain. The income comes from dividends the fund receives on stocks it holds in its portfolio. These it pays out to the fund holders—quarterly, semi-annually or annually. Very nearly all top mutual funds pay out these capital gains to the fund holders, and they are taxable to the fund holders at the 25 percent capital gains tax rate. If the fund retains these gains the fund pays the capital gains tax on behalf of the fund holder. The effect on the fund holder is the same whether the capital gain is held by the fund or paid out by the fund to the holder.


Most top mutual funds send a notice to the fund holders asking them whether they want the capital gain in cash or in shares. Some of the top mutual funds urge the holders to take shares with the result that 70 percent of the fund holders do take them, and thus leave their capital gains in top mutual funds.

This choice that the mutual fund offers the fund holders is not quite what it appears to be.

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