- An open-end fund has a NAV of $20.00 and declares a $0.50-per-share long-term capital gain distribution. Assuming no other change in portfolio value, an investor who owns 1,000 shares elects to reinvest the distribution at the ex-date NAV. Which statement is correct?
Answer: The NAV falls to $19.50, the $500 distribution is taxable in the current year, and the account value is unchanged immediately after the reinvestment.
Mutual fund distribution pricing: a capital gain distribution reduces fund assets, so the NAV drops by the distribution amount, from $20.00 to $19.50. The distribution is taxable in the year received even if the shareholder reinvests it. Reinvesting $500 at $19.50 buys 25.641 additional shares, restoring the immediate account value to $20,000. The statement that the value falls by $500 ignores the new shares received. The statement that the NAV remains $20.00 ignores the reduction in fund assets caused by the distribution. The statement that the distribution is not taxable because it was reinvested incorrectly treats reinvestment as a tax exclusion.
- At the beginning of the year, a no-load mutual fund's NAV is $20.00. During the year, the fund distributes $0.80 per share of non-qualified ordinary dividends and $0.40 per share of long-term capital gains. The investor takes the distributions in cash. At year-end the NAV is $21.00. She is in the 32% ordinary income bracket and the 15% long-term capital gain bracket, and she does not sell any shares during the year. What is her after-tax return for the year, ignoring any tax on the year-end unrealized appreciation?
Answer: 9.42%
After-tax return = (ending NAV - beginning NAV + distributions - current tax on distributions) / beginning NAV. Pretax return = ($21.00 - $20.00 + $0.80 + $0.40) / $20.00 = 11.00%. Current tax = ($0.80 x 32%) + ($0.40 x 15%) = $0.256 + $0.060 = $0.316. After-tax return = ($2.20 - $0.316) / $20.00 = 9.42%. The 11.00% result ignores taxes entirely. The 9.72% result taxes only the dividend distribution and ignores the tax on the capital gain distribution. The 8.67% result also taxes the $1.00 of unrealized appreciation as if it were realized, but unrealized appreciation is not taxed in the current year.
- An investor has an existing account in a mutual fund family worth $30,000. She invests $20,000 in a fund in that family with a NAV of $12.40. The fund imposes a front-end sales charge stated as a percentage of the offering price: 5% for investments under $50,000 and 4% for investments of $50,000 or more. The fund family counts the current value of all existing accounts plus the new purchase toward the breakpoint. Approximately how many shares will the investor receive?
Answer: 1,548 shares
Open-end fund pricing: the public offering price equals NAV divided by (1 - sales charge percentage). The $30,000 existing account plus the $20,000 purchase reaches the $50,000 breakpoint, so the applicable sales charge is 4%. POP = $12.40 / 0.96 = $12.9167, and $20,000 / $12.9167 = 1,548.39 shares, which rounds to 1,548 shares. The 1,613 result omits the sales charge entirely ($20,000 / $12.40 = 1,612.9). The 1,551 result applies the 4% load to NAV rather than to the offering price ($12.40 x 1.04 = $12.896; $20,000 / $12.896 = 1,550.9). The 1,532 result fails to apply the breakpoint and uses the 5% charge ($12.40 / 0.95 = $13.0526; $20,000 / $13.0526 = 1,532.3).
- Which of the following statements regarding the taxation of mutual fund distributions is true?
Answer: A long-term capital gain distribution is taxed at long-term capital gains rates regardless of how long the shareholder has held the fund shares.
Governing authority: IRC § 852(b)(3), which governs capital gain dividends of regulated investment companies. A qualifying mutual fund passes its net long-term capital gains through to shareholders as a capital gain distribution, and the shareholder reports it as a long-term capital gain regardless of how long the shareholder has owned the fund shares. The statement that a capital gain distribution is a qualified dividend is wrong: qualified dividend treatment applies only to the fund's ordinary dividend income, never to its capital gain distributions. The statement that reinvested distributions are not taxed until the reinvested shares are redeemed is wrong: the distribution is taxable in the year paid whether taken in cash or reinvested, and the reinvested shares take a cost basis equal to the amount reinvested. The statement that buying shares before the ex-dividend date avoids tax because NAV falls is wrong: an investor who buys the dividend is taxed on the distribution even though the NAV drop offsets its economic value.
- Which of the following statements regarding the taxable-equivalent yield of a municipal bond fund is true?
Answer: The taxable-equivalent yield is the tax-free yield divided by (1 minus the tax rate), so a 3% tax-free yield equals a 4% taxable yield for an investor with a 25% marginal tax rate.
Governing authority: the taxable-equivalent yield formula used to evaluate tax-free funds. To compare a municipal bond fund with a taxable fund, divide the tax-free yield by 1 minus the investor's marginal tax rate: 3% ÷ (1 - 0.25) = 4%. An investor with a 25% marginal rate would need a 4% taxable yield to match a 3% tax-free yield. Multiplying the tax-free yield by the tax rate gives 0.75%, which is the tax saved, not the equivalent yield. Dividing by the tax rate gives 12%, and adding the tax rate to the yield gives 28%; both misstate the formula's denominator and overstate the required taxable yield.
- An investor will hold a broad-market index fund in a taxable brokerage account for several years. She compares an exchange-traded fund (ETF) with a traditional open-end mutual fund that tracks the same index; both have the same expense ratio and pre-tax performance. Which statement about the relative tax treatment of the two funds is correct?
Answer: The ETF is generally more tax-efficient because in-kind redemptions transfer appreciated securities without triggering a taxable gain at the fund level.
Tax treatment of ETFs and regulated investment companies: ETFs commonly use in-kind redemptions, delivering securities to authorized participants rather than selling them, which can reduce realized capital gains distributed to ETF shareholders. The statement that each authorized-participant redemption is a taxable sale reverses the in-kind mechanism. ETF dividends are taxable when paid, even if reinvested. A regulated investment company is a conduit, but it still realizes gains when it sells portfolio securities; the gains are taxable to shareholders when distributed.
- Which statement about the pricing and tax characteristics of pooled investment products is correct?
Answer: Open-end funds are priced at the next computed NAV after an order; ETFs trade at market prices, and ETF in-kind redemptions can reduce taxable capital gain distributions.
Pooled-vehicle pricing: open-end mutual fund orders are filled at the next computed NAV after the order is accepted, not at an intraday market price. ETFs trade on an exchange at negotiated market prices, and their in-kind redemption process can reduce the fund's realization of built-in gains, making them generally more tax-efficient. The statement that open-end funds trade intraday is reversed. Closed-end funds do not continuously offer new shares at NAV; they trade in the secondary market at prices that can differ from NAV. Unit investment trusts generally have a fixed number of units rather than an unlimited continuous offering, and unitholders are taxed on trust income and distributed gains as they are received, not only when the trust sells securities.
- A mutual fund's NAV is $20.00 at Monday's close. On Tuesday the fund goes ex-dividend and pays a $0.80 per-share ordinary income dividend; the market values of the fund's portfolio securities are unchanged from Monday. An investor owns 1,000 shares in a taxable account and will reinvest the dividend at the new NAV. Immediately after the reinvestment, which statement is correct?
Answer: The investor owns 1,041.67 shares valued at $20,000, and the $800 dividend is taxable in the year received even though it was reinvested.
Mutual fund pricing and tax convention: on the ex-dividend date, the NAV is reduced by the distribution amount, from $20.00 to $19.20. The $800 dividend reinvested at $19.20 buys 41.67 additional shares, so the investor owns 1,041.67 shares. Total value is 1,041.67 × $19.20 = $20,000. In a taxable account, the distribution is taxable in the year received even though it is reinvested. The $20,800 option ignores the NAV reduction and treats the dividend as new value; the nontaxable-reinvestment option incorrectly defers tax; the $19,200 option omits the reinvested shares and incorrectly treats reinvestment as deferring tax.
- Which of the following statements regarding the pricing of open-end mutual fund shares is true?
Answer: An open-end fund fills purchase and redemption orders at a price based on the NAV next computed after the order is received, so an order received before the 4:00 p.m. Eastern close is priced at that day's NAV.
Governing authority: Investment Company Act Rule 22c-1 (forward pricing). An open-end fund must execute purchase and redemption orders at a price based on the NAV next computed after the fund receives the order. Because funds generally compute NAV once daily at 4:00 p.m. Eastern time, an order received before the close is priced at that day's NAV and an order received after the close is priced at the next business day's NAV. The statement that an order received after the close is also priced at that day's NAV describes late trading, which the rule prohibits. The statement that a pre-close order is priced at the prior day's NAV is wrong because pricing a pre-close order at the prior day's NAV violates the forward-pricing requirement of Rule 22c-1; the order must receive the NAV next computed, which is that day's 4:00 p.m. NAV. The statement that purchases are made at NAV plus a spread and redemptions at NAV less a spread is wrong: open-end shares are bought and redeemed at a single computed NAV (plus any stated sales charge on purchases), and bid-ask spreads are a secondary-market feature of ETFs and closed-end funds.
- An investor places a $10,000 purchase order in an open-end mutual fund. The fund's NAV at the time of purchase is $12.00, and its stated sales charge is 4% of the public offering price. If the fund imposes no other fees, approximately how many shares will be credited to the investor's account?
Answer: 800 shares
Mutual fund pricing convention: when a sales charge is stated as a percentage of the public offering price, the offering price equals NAV divided by (1 - sales charge percentage). Here POP = $12.00 / (1 - 0.04) = $12.50, so a $10,000 order buys $10,000 / $12.50 = 800 shares. The 833-share answer ignores the sales charge. The 801-share answer applies the 4% load to NAV and computes $12.00 × 1.04 = $12.48. The 768-share answer deducts the dollar load from the order and then divides by the offering price, double-counting the charge.
- Which of the following statements regarding the total return of a mutual fund is true?
Answer: Total return reflects the change in the fund's NAV plus income dividends and capital gain distributions, assuming all distributions are reinvested in additional shares.
Governing authority: the definition of total return as a fund performance measure. Total return captures the complete economic return to a fund shareholder: the change in NAV plus income dividends and capital gain distributions, with distributions assumed reinvested. The statement that total return is ending NAV divided by beginning NAV ignores distributions and measures only NAV appreciation. The statement that total return excludes capital gain distributions is wrong: those distributions are income to the shareholder and must be added back even though the NAV falls by the amount distributed. The statement that total return measures only income dividends confuses total return with yield; total return includes capital appreciation as well as income.
- An investor makes a $10,000 purchase payment into an open-end mutual fund. The fund has a 5% front-end sales charge based on the offering price and a NAV of $20.00 at purchase. During the year, the fund's portfolio appreciated 8%, and the fund's expense ratio was 1%. The fund paid no distributions. Using the common approximation that the expense ratio reduces the fund's total return by 1%, what is the approximate year-end account value?
Answer: $10,165
Mutual fund performance evaluation concept: the sales charge is embedded in the offering price. With a 5% load, the $10,000 payment buys 475 shares, because the offering price is $20.00 / (1 - 0.05) = $21.0526. The net return is approximately 8% - 1% = 7%, so the ending NAV is $20.00 × 1.07 = $21.40. Account value is 475 × $21.40 = $10,165. The $10,260 answer includes the load but omits the expense ratio; the $10,700 answer omits the load but includes the expense ratio; the $10,800 answer omits both the load and the expense ratio.
- An IAR is comparing two no-load mutual funds for a client's taxable account. Both funds had the same 9% pretax average annual return over the past 10 years. Fund A is a low-turnover index fund with a 0.10% expense ratio. Fund B is an actively managed fund with a 0.85% expense ratio and a 120% portfolio turnover rate. Which conclusion is most accurate?
Answer: Even with equal pretax returns, Fund B likely has the lower after-tax return because higher turnover creates taxable distributions, and reinvesting them does not avoid tax.
Mutual fund performance evaluation: reported fund returns are net of fund expenses, but they do not reflect the investor's tax liability on fund distributions. A fund's realized capital gain distributions are taxable to shareholders in the year distributed, even if the shareholder reinvests them. High turnover tends to increase those taxable distributions, which can reduce after-tax return in a taxable account. Reinvesting distributions does not defer or eliminate the tax. The statement that after-tax returns must be equal ignores the tax cost of the fund's realized gains. Capital losses generally are not passed through to shelter the shareholder's other income, and mutual fund shareholders are taxed on current income and capital gain distributions, not only when they sell their own shares.
- An investor purchased 1,000 shares of a mutual fund at $20.00 per share. While holding the fund, the investor received a $2,000 ordinary dividend and a $1,000 long-term capital gain distribution, both automatically reinvested at $22.00 per share. The investor later sold all of the shares in 2026 for $25.00 per share. Which of the following statements is correct regarding the investor's tax basis and gain or loss on the sale?
Answer: Basis increases to $23,000, and the sale produces a gain of $5,409, because reinvested distributions are taxable when received and the reinvested amount becomes part of cost basis.
Under federal income tax law, reinvested mutual fund distributions are taxable to the shareholder in the year received and increase the shareholder's cost basis. Initial basis is $20,000. The $3,000 of reinvested distributions raises basis to $23,000. The reinvestment at $22 per share buys 136.36 additional shares, so the investor sells 1,136.36 shares at $25, for proceeds of $28,409. The gain is $28,409 - $23,000 = $5,409. The $8,409 option ignores the basis increase; the $2,409 option double-counts the reinvested distributions; the no-gain option incorrectly treats reinvestment as a tax-free exchange.
- An investor bought 1,000 shares of a mutual fund six years ago for $10.00 per share. Over the holding period, the fund made dividend distributions totaling $1,500 and capital gain distributions totaling $800. All distributions were reinvested at NAV and were taxable in the years received; the last reinvestment was more than one year ago. Her account statement now shows 1,230 shares. She redeems all of her shares at a NAV of $14.00, and the fund imposes no redemption fee. Her ordinary income tax rate is 24% and her long-term capital gain rate is 15%. What is the federal income tax on the redemption?
Answer: $738
Under federal income-tax cost-basis rules for mutual funds, reinvested distributions are taxable when received and are added to the shareholder's aggregate cost basis. Basis = $10,000 + $1,500 + $800 = $12,300. Redemption proceeds = 1,230 x $14.00 = $17,220. The gain is $4,920, and because every share has been held more than one year, it is long-term. Tax = 15% x $4,920 = $738. The $600 result uses only the original 1,000 shares and the original $10,000 basis, ignoring the reinvested shares and distributions. The $963 result adds only the capital gain distributions to basis, omitting the $1,500 of dividends. The $1,181 result applies the 24% ordinary rate to the $4,920 long-term gain.
