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Your fund’s distributions can come from various sources—interest earned on the securities held in the fund, price appreciation from
securities sold from the portfolio, and return of principal. The following Q&A takes a look at return of principal, explains why this may
occur, what it means and what the tax implications may be.
A: Each month, the Board of Directors approves the dividend to be
paid to shareholders. Generally, this dividend is calculated by
taking the total investment income that the fund is expected
to earn, and then subtracting various fund expenses from that
amount. The result is the net investment income—the amount
available to pay out to shareholders in the form of a dividend.
One of the fund’s goals is to maintain a stable dividend level
over time. Occasionally, however—especially in a difficult credit
environment—a fund may “under-earn” its dividend. In other
words, the interest earned on bonds held in the portfolio is less
than originally anticipated. It is also possible that a fund may,
on occasion, “over-earn” its dividend.
A: Typically, each fund maintains reserves to help subsidize
unexpected shortfalls in the portfolio’s income stream. If this
cushion is exhausted, however, a portion of the dividend must
come from a source other than the fund’s net investment
income. This source is considered “principal” for accounting
purposes because it comes from the fund’s initial investment
monies. Therefore, if a fund must draw from principal to
maintain its dividend payment, shareholders will receive notice
that a portion of the accompanying distribution includes
something other than net investment income—that is, a “return
of principal.”
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A: Not necessarily. Return of principal is strictly an accounting
concept and therefore, has no tax treatment. What does matter
for tax purposes is a return of capital. And whether a fund’s
return of principal ultimately translates to a return of capital
for tax purposes is determined at the end of the fund’s fiscal
year. Here’s why: A fund’s return of principal is calculated
as of the date of the dividend, whereas a return of capital
aggregates together all dividends paid during a year and is
determined at year end.
For example, assume your fund under-earns its dividend in a
month and there is no cushion to draw from. In this case, you
would receive a return of principal (for accounting purposes),
regardless of whether the fund over-earns its dividend in a
following month. However, in order to determine whether you
will have a return of capital for tax purposes at the end of the
year, the amount of all dividends paid to shareholders in the
fund during the entire fiscal year must be totaled—that’s because
a shortfall one month may have been offset with an excess
in another month or months. In that case, there would be no
return of capital to you, as a shareholder, for tax purposes. If at
year-end the net result is a shortfall, however, the amount of the
shortfall would be considered a return of capital to shareholders,
and would need to be treated as such for tax purposes.
Another potential reason why you might have a return of
principal but not a return of capital, or vice versa, is that some
securities require different treatment for tax purposes than they
do for book accounting purposes. Generally, the effect of a
return of capital on your taxes is that it reduces your original
cost basis of the shares you purchased in the fund.
A: Whatever portion, if any, of your annual distribution includes
a return of capital is reported to you on your Form 1099-DIV
as Nondividend distributions, which you should receive in
mid February. As always, you should consult with your tax advisor if you have any questions about the treatment of fund distributions on your
tax returns. If you have questions about your Van Kampen fund, or any of our
other products, please contact your financial advisor. Van Kampen does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It was
not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be
imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. You should
always consult your own legal or tax advisor for information concerning your individual situation. There is no assurance that a mutual fund will achieve its investment objective. Funds are subject to market risk, which is the
possibility that the market values of securities owned by the fund will decline and that the value of fund shares may therefore be less
than what you paid for them. Accordingly, you can lose money investing in a fund.
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