Investment Company and Variable Contracts Products Representative (Series 6)Practice Exam

What happens to taxes if a mutual fund investor chooses to reinvest dividends?

1. Taxes will be deferred

2. Taxes must be paid immediately

3. No tax impacts reinvestment

4. Taxes will increase substantially

The correct answer is: Taxes will be deferred

When an investor chooses to reinvest dividends from a mutual fund, the internal workings of the taxation system come into play regarding the tax treatment of those dividends. While the dividends are reinvested to purchase additional shares, the investor is still considered to have received those dividends for tax purposes in the year they were distributed. This means that taxes are not deferred; they must still be reported in the year they are paid out, even if the investor chooses to reinvest them. It's important to note that while the reinvestment itself does not defer taxes, it can allow an investor to compound their investment over time. The investor does owe taxes on the full amount of the dividends received, regardless of whether they take the dividends in cash or reinvest them back into the fund. This principle helps clarify other options. Taxes are not deferred since the investor incurs a tax liability in the fiscal year the dividends are recorded, regardless of the reinvestment. While it may seem that there are no immediate cash transactions impacting the investor when opting to reinvest, the tax on dividends is still applicable. The notion that taxes might increase substantially is not inherent to the reinvestment choice itself; rather, it depends on other factors like the investor's overall income and tax bracket