"That sounds great, Roy, but if I'm reinvesting the dividends, where do I get the money to pay the tax owing?" I interjected worriedly.
"From your father," Roy deadpanned. "No, the dividend distributions are usually small and, therefore, so is the tax liability. It will not be enough in the early years to even discuss. In the later years you'll be so wealthy it won't be a problem then either." It was plain from Roy's tone that he did not mean the last line sarcastically. "In addition to your small annual tax on the declared dividend, obviously you must also pay tax on the capital gain when you sell some or all of your mutual fund shares. Congress finally came to its senses last year and reduced the capital-gains tax. By the time you're ready to sell, who knows, maybe it will be eliminated altogether—the gains tax that is, not Congress. We need to encourage, not discourage, investment. It's important to note that, on selling, you do not have to pay tax again on reinvested dividends—not even the IRS would try that. By the way, managers that trade less frequently generate lower annual tax bills . . . worth keeping in mind.
"It's also important to note that if you've kept all your purchase statements, and I advise you to do so, and if you are selling some, but not all, of your accumulated shares, there is an excellent tax strategy available. Instruct the fund company to sell the shares for which you've paid the most. By telling them the date of purchase of those shares and the price, you'll make it possible for them to honor your request. Moreover, it may not hurt to ask them for a written confirmation verifying that you sold the highest-cost shares in case Uncle Sam comes calling. By employing this strategy, you create smaller taxable profits and defer tax for a while—not eliminate it, of course, but simply defer.