This answer is applicable to the US. Similar rules may hold in some
other countries as well.
The shares in an open-ended (non-exchange-traded) mutual fund are not
traded on stock exchanges and the "market" does not determine the share
price the way it does for shares in companies as brokers make offers to
buy and sell stock shares. The price of one share of
the mutual fund (usually called Net Asset Value (NAV) per share) is usually calculated at the close of business, and is, as the name implies, the net
worth of all the shares in companies that the fund owns plus cash on hand
etc divided by the number of mutual fund shares outstanding.
The NAV per share of a mutual fund might or might not increase in anticipation
of the distribution to occur, but the NAV per share very definitely falls on
the day that the distribution is declared. If you choose to re-invest
your distribution in the same fund, then you will own more shares
at a lower NAV per share but the total value of your investment will not
change at all. If you had 100 shares currently priced at $10 and
the fund declares a distribution of $2 per share, you will
be reinvesting $200 to buy more shares but the fund will be
selling you additional shares at $8 per share (and of course, the
100 shares you hold will be priced at $8 per share too. So, you
will have
100 previous shares worth only $800 now + 25 new shares worth $200
for a total of 125 shares at $8 = $1000 total investment, just as before.
If you take the distribution in cash, then you still hold the 100
shares but they are worth only $800 now, and the fund will send you
the $200 as cash. Either way, there is no change in your net worth.
However, (assuming that the fund is is not in a tax-advantaged account),
that $200 is taxable income to you regardless of whether you reinvest
it or take it as cash. The fund will tell you what part of that $200
is dividend income (as well as what part is Qualified Dividend income),
what part is short-term capital gains, and what part is long-term capital
gains; you declare the income in the appropriate categories on your
tax return, and are taxed accordingly.
So, what advantage is there in re-investing?
Well, your basis in those shares has increased and so if and when
you sell the shares, you will owe less tax. If you had bought the
original 100 shares at $10 and sell the 125
shares a few years later at $11 and collect $1375, you owe (long-term
capital gains) tax on
just $1375-$1200
=$175 (which can also be calculated as $1 gain on each of the original
100 shares = $100 plus $3 gain on the 25 new shares = $175).
In the past, some people would forget the intermediate transactions and think
that they had invested $1000 initially and gotten $1375 back for
a gain of $375 and pay taxes on $375 instead. This is less likely
to occur now since mutual funds are now required to
report more information on the sale
to the shareseller than they used to in the past.
So, should you buy shares in a mutual fund right now? Most mutual
fund companies publish preliminary estimates in November and December
of what distributions each fund will be making by the end of the
year. They also usually
advise against purchasing new shares during this period because
one ends up "buying a dividend". If, for example, you bought those
100 shares at $10 on the Friday after Thanksgiving and the fund distributes
that $2 per share on December 15, you still have $1000 on
December 15, but now owe taxes on $200 that you would not have
had to pay if you had postponed buying those shares till after the
distribution was paid.
Nitpickers: for simplicity of exposition, I have not gone into the
detailed chronology of
when the fund goes ex-dividend, when the distribution is recorded,
and when cash is paid out, etc., but merely treated all these events
as happening simultaneously.
