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Dividends and Capital Gains

Overview

Introduction Dividends and capital gains are distributions to shareholders of income and

gains earned by a mutual fund portfolio. They represent two of the threeways mutual funds produce increased value for shareholders.

In this chapter This chapter explains the process mutual funds use to distribute earnings to

shareholders.

TopicDividend ConceptsPeriodic Dividend FundsDaily Dividend FundsMoney Market FundsCapital GainsReinvestmentImpact on NAV

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Dividend Concepts

Introduction Under subchapter M of the Internal Revenue code, mutual funds are required

to distribute at least 90% of net investment income annually to qualify as aregulated investment company and 98% of income to avoid the imposition ofan excise tax.

Mutual funddividends

Mutual fund dividends are distributions to shareholders of income earned bya funds portfolio, net of the operating expenses of the fund. This income isderived from two sources:

dividends paid to the portfolio by stocks held in the portfolio, and interest paid to the portfolio by bonds held in the portfolio.

Dividend rate A dividend rate is the total dollar amount to be distributed, divided by the

number of outstanding (dividend eligible) shares. It is expressed as cents-per-share.

Frequency ofdistributions

Mutual funds usually distribute dividends on a set schedule, as outlined in thefund prospectus. Following are some typical distribution patterns:

daily monthly

quarterly semi-annual annual.

Specialdeclaration orrevocation

All dividends must be declared by a funds board of directors. At times, theboard of directors may declare a special dividend, or may revoke a dividendthat was scheduled.

Dividendentitlement

Mutual funds determine entitlement to dividends based on either trade date or

settlement date.Continued on next page

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Dividend Concepts, Continued

Trade date Trade date is the date on which an order to buy or sell mutual fund shares is

processed.

Equity funds use trade date to establish dividend entitlement.

Settlement date Settlement date is the date on which the transaction is completed, meaningshares are actually exchanged for cash (or vice versa) in a mutual fundaccount. Settlement date is usually either one or three business days aftertrade date.

Income funds and money market funds generally use settlement date (or some

calculation from settlement date) to establish dividend entitlement.

Shareholderoptions

Shareholders can choose to have dividends:

credited as cash to their brokerage account mailed to them in the form of a check used to purchase additional mutual fund shares.

Dividends byshare class

Mutual funds usually distribute different dividend amounts to each shareclass, reflecting the different cost structure of each class.

Taxability Most distributions of income by mutual funds, except for certain distributionsby tax free bond or money market funds, are taxable to the shareholder,whether the dividend is taken in cash or reinvested to purchase additionalshares.

Dividends are normally considered ordinary income, and taxed at theshareholders regular income tax rate.

Reportability Mutual funds issue all shareholders a form 1099-Div each year, listing theamount of all dividend distributions.

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Dividend Concepts, Continued

Classification

based ondividends

Mutual funds are classified into three categories for purposes of dividend

distributions:

Equity funds (also called periodic funds, or equities) Daily dividend funds (also known as daily accrual funds, income funds,

bond funds, or dailies) Money Market funds.

Comparison ofdistributionmethods

The table below compares various aspects of the dividend distributionmethods of the three categories of funds.

Aspect Distribution Method

Equity Daily Money Market

categoryconsists of

growth funds growth and

income funds

income funds money marketfunds

income earnedby the portfoliois

included in netassets everyday, causingthe NAV torise

placed in apendingdistributionaccount daily

not reflectedin the NAV

placed in apendingdistributionaccount daily

not reflectedin the NAV($1.00 per

share)Net Asset Value is impacted

when adividend ispaid

is not directlyimpactedwhen adividend pays

is not directlyimpactedwhen adividend pays

shareholderentitlement todividends

based on tradedate

based onsettlementdate

based onsettlementdate orsettlementdate plus oneday

dividends areusuallydistributed

monthly,quarterly,semi-annuallyor annually

monthly (inrare cases,quarterly)

daily ormonthly

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Periodic Dividend Funds

Introduction Equity funds usually distribute dividends at regular periodic intervals.

Key dates There are several key dates associated with equity fund dividenddistributions.

Record Date Ex Date Payable date

Record date Record date is a date, chosen by the funds board of directors, which

determines whether or not a shareholder is entitled to a dividend distribution.To be entitled to an equity dividend distribution, an investor must be ashareholder of record on record date.

Shareholder ofrecord

A shareholder of record on a particular date is one with shares in the accountas-of the close of business that date.

Record dateactivity

Shares purchased (trade date) on record date qualify as shares of record.Shares liquidated (trade date) on record date do not qualify as shares of

record.

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Periodic Dividend Funds, Continued

Ex date Ex date is the first date that the equity mutual fund sells without (ex) the

dividend included in its NAV. This is almost always the next business dateafter record date.

Entitlementbased on exdate

Entitlement for a dividend distribution can be established by considering exdate. The rules are as follows:

Purchases placed before ex date are entitled to the dividend. Purchases placed on or after ex date are not entitled to the dividend. Liquidations placed on or after ex date are entitled to the dividend. Liquidations placed prior to ex date are not entitled to the dividend.

Note: placed refers to trade date.

Payable date Payable date is the date that dividend distributions are credited to shareholder

accounts. This date can be anytime after record date.

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Periodic Dividend Funds, Continued

Equity

dividendsimpact on NAV

Income to be distributed as a dividend remains part of the funds NAV until

ex date. On ex date, the NAV is reduced by the amount of the dividend. Thetable below illustrates the impact of an equity dividend payout on NAV.

Who When What

XYZ Biotech fund Initially (January1)

began with $100,000 in assets issued 10,000 shares had an initial NAV of $10.00

per shareXYZ Biotech fund At the end of the

first quarter ofoperation (April 5)

has had no expenses did not issue or redeem any

shares

earned $5,000 in interest anddividends from the assets inits portfolio

has an NAV of $10.50 pershare($105,000/10,000=$10.50)

XYZ Biotechsboard of directors

April 10 decides to distribute all of theincome earned by the fund

declares a dividend withrecord date set as April 15, exdate set as April 16, andpayable date set as April 25

XYZ Biotech fund April 15 (recorddate)

still has an NAV of $10.50

XYZ Biotechsboard of directors

April 16 (ex date) Removes the $5,000 from thefunds assets and puts it in apending dividend distributionaccount (this will decreaseNAV by $0.50 per share)

XYZ Biotech fund April 16 (ex date) now has an NAV of $10.00XYZ Biotech fund April 25 (payable

date) pays a dividend of $0.50 per

share to all shareholders ofrecord as of April 15

Note: The NAV is not impactedby this payment event.

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Periodic Dividend Funds, Continued

Dividend

entitlementrelative to NAVpaid/received

The table below illustrates which investors (buyers or sellers) are entitled to

the dividend in the previous example, and relates their entitlement to theNAV they either paid for purchases or received for liquidations.

An investor whois a...

and who placesthe trade...

will...

buyer prior to ex date(April 16)

pay $10.50 per share, whichincludes the $5,000 in income,and will

be entitled to the dividendwhen it pays.

buyer on or after ex date

(April 16 )

pay $10.00 per share, which

does not include the $5,000 inincome, and will not be entitled to the

dividend.seller prior to ex date

(April 16) receive $10.50 per share for

the liquidation, which includesthe $5,000 in income, and will

not be entitled to thedividend, as the income wasalready reflected in the $10.50NAV.

seller on or after ex date(April 16 )

receive $10.00 per share forthe liquidation, which does notinclude the $5,000 income,and will

be entitled to the dividendwhen it pays.

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Daily Dividend Funds

Introduction Daily dividend funds accrue the income received by the portfolio daily.

Accrual period An accrual period is a series of consecutive dates, usually about 1 month in

duration, during which a daily dividend fund accumulates dividends in thepending distribution account.

Daily rate Daily dividend funds calculate a rate each day, called the daily rate, ordividend factor. The rate is equal to the earnings on the funds portfolio thatday, divided by the total outstanding shares.

Dividendbucket

An amount equal to the daily factor times the fund assets is held separatefrom the portfolio each day in a pending distribution account, often called thedividend bucket.

Note: Dividends are also bucketed daily at the shareholder level.

Key dates With daily dividend funds, shares earn dividends for every day they are

settled in the account. The important dates for daily dividend funds aresettlement date and the accrual period.

Purchasesettlement

Most daily dividend funds consider purchases entitled to the daily dividendrate beginning on settlement date. A few begin on settlement date plus 1day.

Liquidationsettlement

Most daily dividend funds consider liquidated shares entitled to the dailydividend rate up to but not including settlement date. In cases wheredividend entitlement for purchases begins on settlement date plus one,liquidations are entitled to dividends through settlement date.

Paydate Paydate is the day the dividends are credited to shareholder accounts, usuallythe last business date of the accrual period.

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Daily Dividend Funds, Continued

Distribution

illustration

Most daily dividend funds distribute the income they have accumulated on a

scheduled monthly basis. The table below illustrates the process:

Stage Description

1 A daily dividend rate is calculated each day, by the fundsaccounting agent, for the entire accrual period.

2 At the end of the accrual period, a cumulative rate is calculated.3 On paydate the cumulative rate is multiplied by the number of

shares held for the entire accrual period and a dividend in thatamount is credited to the shareholder.

Distribution forshares held forpart of anaccrual period

To determine the correct dividend for shares settled in the account for aportion of the accrual period, the applicable daily rates are multiplied timesthe applicable daily positions for each shareholder.

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Daily Dividend Funds, Continued

Daily factors Daily dividend factors are:

expressed as cents-per-share usually displayed as one to six decimal places calculated for every day of the accrual period accumulated on non-business days (weekends and holidays), and added to

the next business day in next day funds, or the prior day in same dayfunds.

Exampleaccrual period

The table below illustrates a daily dividend accrual period, resulting in acumulative dividend rate of $0.05996 per share.

Date Factor Date Factor

02/01/97 N/A 02/16/97 N/A02/02/97 N/A 02/17/97 .0064302/03/97 .00643 02/18/97 .0021402/04/97 .00214 02/19/97 .0021402/05/97 .00214 02/20/97 .0021402/06/97 .00214 02/21/97 .00214

02/07/97 .00214 02/22/97 N/A02/08/97 N/A 02/23/97 N/A

02/09/97 N/A 02/24/97 .0064302/10/97 .00643 02/25/97 .0021402/11/97 .00214 02/26/97 .0021402/12/97 .00214 02/27/97 .0021402/13/97 .00214 02/28/97 .0021402/14/97 .0021402/15/97 N/A

Total .05996

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Money Market Funds

Introduction Money market funds are similar to daily dividend funds in the way dividend

distributions are executed.

Purchasesettlement formoney marketfunds

Most money market mutual funds consider purchases entitled to the dailydividend rate beginning on settlement date plus one day.

Liquidationsettlement formoney market

funds

Most money market mutual funds consider liquidated shares entitled to thedaily dividend rate up to and including settlement date.

Two types ofdistribution

Money market funds distribute the interest income earned on their portfoliosaccording to one of the following policies:

paid and reinvested daily, (at Merrill Lynch, the Ready Asset TrustFamily of money market mutual funds) or

accrued daily, compounded and paid monthly (at Merrill Lynch the CMAFamily of money market mutual funds).

Dailydistributions

Daily distributions are credited to shareholder accounts daily.

Monthlydistributions

Monthly distributions for money market funds are processed the same way asdaily dividend funds are processed. Income is accrued daily for a set period,and distributed once per month.

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Capital Gain Concepts

Introduction Mutual funds are not required by law to distribute capital gains earned on the

sale of portfolio holdings. However, most funds do distribute the majority ofthis income to avoid paying taxes on those gains at the corporate tax rate.

Sources ofearnings

The money that mutual funds earn and then distribute to shareholders ascapital gains comes from net profits on the sale of portfolio assets.

Methodology All capital gain distributions, including capital gains paid by daily

dividend funds, follow the same rules for eligibility and distribution asequity fund dividends.

Taxability Capital gains are always taxable. Even tax free municipal bond mutual funds

occasionally have a capital gain distribution, which is taxable to theshareholder. Capital gains are taxable as follows:

Type of capital gain Length of time

securities were held inthe funds portfolio

Tax rate

Short-Term less than 1 year the shareholdersnormal tax rate

Long-Term - 28% between 1 year and 18

months

maximum of 28%

Long-Term - 20% more than 18 months maximum of 20%

Reportability Mutual funds issue all shareholders a form 1099-Div each year, listing theamount of all capital gains distributions.

Shareholderoptions

Shareholders can choose to have capital gains:

credited as cash to their brokerage account

mailed to them in the form of a check used to purchase additional mutual fund shares.

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Reinvestment

Introduction A key feature of mutual funds is the option to reinvest dividends and capital

gain distributions to purchase additional shares.

Reinvestmentoptions

Mutual funds usually offer shareholders several reinvestment options at thetime an account is established. The selection can also be changed thereafter.These options are to have:

all dividends and distributions credited as cash dividends credited as cash and capital gains reinvested dividends reinvested and capital gains credited as cash all dividends and distributions reinvested.

Thereinvestmentprocess

In the reinvestment process, the cash value of the dividend or capital gain(per-share rate times the number of shares held by the shareholder) is used topurchase additional shares of the fund.

The table below illustrates the steps involved in a dividend reinvestment.

Assumptions:Who What

XYZ Biotech fund has an NAV of $9.00 (after paying out aquarterly dividend)

paid out a dividend of $.50 per shareInvestor holds 500 shares of XYZ Biotech fund

Calculations:Who What

Investor is entitled to a dividend of $250.00 (dividendrate of $0.50 per share times 500 shares)

has selected the reinvestment optionTransfer Agent forXYZ Biotech fund

places a purchase for the investor on payabledate, buying $250.00 worth of the fund ($250.00

divided by $9.00 = 27.778 shares)Investor receives 27.778 shares on payable date (or soonthereafter), bringing the share total to 527.778shares

Continued on next page

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Reinvestment, Continued

Reinvest

pricing

Reinvestment trades are almost always placed at NAV.

Equity fundreinvestmentprice

Equity funds usually price reinvestment purchases at the NAV of ex date.

Daily dividendfundreinvestmentprice

Daily dividend funds usually price reinvestment purchases at the NAV ofpaydate, or paydate plus one day.

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Impact on NAV

Introdu

ction

The following pages illustrate the impact of dividend and capital gain

distributions on NAVs.

EquityFunds

The NAV of an equity fund usually decreases by approximately the sameamount as the dividend rate, on ex date.

DailyDividendFunds

Daily dividend funds keep earnings separate from the portfolio, and so theyare not reflected in the NAV. Thus when the income is distributed, there islittle or no impact on the NAV.

MoneyMarket Funds

Money market mutual funds maintain their NAV at $1.00 by distributing (oraccruing) income every day. Distributions therefore do not impact NAV.

CapitalGains

Capital gain distributions follow the same process as equity funddistributions. The NAV of an equity fund (or of a daily dividend fund payinga capital gain) usually decreases by approximately the same amount as thecapital gain, on ex date.

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Equity D ividend ProcessDividend Rate

Each circle represents the portfolio, and therefore the NAV onsuccessive days.

With equity (or periodic) funds, income that the portfolio receives fromits holdings (net of expenses) remains in the portfolio causing it to expand and

therefore the NAV to increase.

On the night of record date, the income to be distributed is carved out ofthe portfolio and placed in a pending distribution account (also known as thedividend bucket), causing the portfolio to shrink and therefore the NAV todecrease. The NAV decreases by the amount of income removed per share. Thisincome per share is called the dividend rate.

If an investorbuys on or before record date , he has paid a price per sharewhich includes the income, and therefore he is entitled to the dividend when it

pays.

If an investorsells on or before record date , he receives proceeds basedon the price per share which includes the income, and is therefore not entitled tothe dividend when it a s.

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Daily Dividend Process

.002 .011 .021 .002

Daily Dividend Rates

Cumulative

Rate

Each circle represents the portfolio, and therefore the NAV on successive days. With daily dividend funds, income (net of expenses) that the portfolio receivesfrom its holdings is paid out every day by being placed in a pending distributionaccount (also known as the dividend bucket), thereby keeping the NAV relatively flat.(Note: The NAV can increase slightly as a result of capital appreciation of portfolio

holdings.)

Each day, a dividend rate is calculated which is the income for that day dividedby the outstanding (settled) shares for that day.

The current days income is added to the previous days in the bucket, thuscausing the pending distribution account (bucket) rather than the NAV to increase.

At the end of each accrual period (usually about 30 days), dividends are paidout (the bucket is emptied) and the process begins again.

Shareholders with a single share amount settled in the account for the entireaccrual period receive the cumulative dividend factor (sum of all the daily rates) timesthe number of shares they have settled in the account.

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Money Mark et D ividend Process

Money market funds distribute income in a similar manner to dailydividend funds. Each day, a rate is calculated based on the funds income,expenses, and $1.00 per share NAV , and paid out in one of two ways:

In the first scenario, money market funds accumulate daily interestincome (in the pending distribution account) for a period (usually about 30 days)and then pay out on pay date.

Note: Interest in the pending distribution account compounds daily.The dividend that pays out on pay date includes this compound interest.

In the second scenario, money market funds pay out (empty the bucket)daily. In this case, the shareholder earns dividends on the previously paiddividends, also accomplishing compounding.

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Capital Gain ProcessCapital Gain Rate

The capital gain distribution process works in exactly the same manneras the equity distribution process. It works this way for both equity and dailydividend funds.

Equity (or periodic) funds sometimes distribute capital gains at the sametime as they distribute their regular income dividend. In those cases, two separaterates are declared.

When daily dividend funds distribute capital gains they declare a record,ex and pay date, just as an equity fund does. This distribution is completelyseparate from and has no bearing on the regular monthly income distributionprocess.