Mutual Funds and
Mutual funds offer
many benefits such as diversification, professional management and convenient
purchase options. However, the income tax issues associated with mutual
funds can be confusing.
equities through a mutual fund will not save you any taxes. But there
are some things you should know. You may also want to consult your tax
advisor to get a more complete understanding of how the tax consequences
of owning mutual funds may directly affect you.
The basic rules
Mutual funds do not pay income taxes directly. The tax laws under which
they operate provide for mutual funds to pass along earnings and tax consequences
to the mutual fund shareholders. Mutual funds distribute dividends, interest
and net realized capitalized gains to the shareholders. Most mutual funds
make these distributions late in the year and report them on Form 1099.
The fund shareholders then list these distributions on their individual
income tax returns.
Qualifying dividends and long term capital gain distributions receive
favorable tax treatment. For taxpayers in the 10% and 15% brackets, qualifying
dividends and long term capital gains (assets held for more than a year)
will be taxed at 0%. For those in 25%, 28%, 33% and 35% tax brackets,
the tax rate on dividends and long term capital gains is 15%. For those
in the top 39.6% bracket, the tax rate is 20%.
Interest income will continue to be taxed as ordinary income at rates
up to 39.6%. Most distributions from money market funds and bond mutual
funds consist of interest subject to the higher rates.
It is important to note that these distributions are taxed even if you
have them reinvested into additional shares of the fund. If you hold funds
in an IRA or 401(k) plan, the distributions are not taxed. You are taxed
only on distributions from these tax-qualified plans.
Unfortunately, since most distributions are made late in the year, it
can be difficult to include the impact of potential distributions in your
income tax planning. If the mutual fund portfolio has a high turnover
ratio, there may be unexpected capital gains distributions even if the
value of the fund shares stays relatively constant or declines. In addition,
if your fund's high turnover rate produces short-term gains, they will
be taxed at the higher ordinary income tax rates.
When evaluating a mutual fund, determine the level of portfolio turnover
and you will be able to get a better idea of the impact of the manager's
investment strategy on the tax consequences of ownership. The higher the
turnover, the more likely you will have your return eroded by taxes.
Taxes when selling
your mutual fund shares
One of the most difficult parts of owning mutual funds can be keeping
track of your cost basis in the shares you own. The cost basis, which
you compare to the sales proceeds when determining whether you have a
gain or loss, must be determined carefully. Your basis starts with the
original price you paid for the shares. If you have distributions actually
made to you, your original basis remains your basis and your holding period
for the shares starts when you made your original purchase.
However, if you have
distributions reinvested in additional shares of the fund, determining
your basis is more difficult. Any distributions you have reinvested are
considered to be new purchases of fund shares. When you sell the mutual
fund shares, you need to increase your basis to reflect that you have
paid taxes on the distributions and bought new shares. The holding period
for the new shares begins when the distributions are reinvested. For example,
if you bought shares years ago and had the distributions reinvested, your
total basis will include what you originally paid and all the taxable
distributions you reported on your Form 1040. If you sell all your shares,
there will probably be some shares you have held for less than the one-year
period to qualify for long-term treatment.
Be aware that income taxes can erode the returns of your mutual funds.
Look at the historical turnover tendencies of the portfolio manager to
get some idea of whether they may be a likelihood of unexpected tax costs.
Lastly, keep good tax records. When you finally sell your shares, you
will need to know your tax basis and the only way to determine it is from