Funds and Taxes

Fund Taxes

The decision to buy or sell mutual fund shares can impact how much you pay in taxes. Understanding mutual fund tax issues can help you keep an eye on taxes, while still working toward your long-term financial goals.

When you sell shares in a mutual fund, whether by redeeming, exchanging or writing a check, you have triggered a taxable event, unless the transaction occurred in a tax-deferred retirement plan or a money market fund. At tax time, you'll need to report any gain or loss on your taxes.

When it comes to taxes and your investments, there is a lot to think about. You may want to consult a tax professional for information tailored to your personal situation.

How Capital Gains Work

Investors in mutual funds can be taxed on both the income a fund makes while you own its shares -- known as capital gains -- and on the profits you make when you exchange or sell shares.

Capital gains can be defined as the difference between an asset's purchase price and selling price, when the difference is positive. (A capital loss would be when the difference between an asset's purchase price and selling price is negative.) Gains come in two forms, unrealized and realized:

  • Unrealized gains are gains on paper only and aren't taxed until the gains are realized and distributed to shareholders. A fund can post a large return and not trigger taxes for its shareholders if the securities appreciate and are not sold.
  • Realized gains occur when an asset that has appreciated in value is sold. At that point, the profit is taxable as a capital gain.

There are two categories of capital gains:

  • Short-term gains and losses occur when the assets are held one year or less. Short-term gains are taxed at your ordinary income tax rate. Short-term capital losses can be used offset short-term capital gains.
  • Long-term gains and losses occur when the assets are held longer than 12 months. Long-term capital gains are generally lower than your ordinary income tax rate. Long-term capital losses can be used offset long-term capital gains.

IRS capital gains tax rates and information

Distributions

Mutual funds are required to distribute income and net realized gains to its shareholders. Owning a mutual fund in a taxable account when it pays a distribution can affect your tax bill. Types of distributions include:

  • Income dividends. Interest, dividends or short-term capital gains earned from the securities in the portfolio, after fund expenses are deducted.
  • Capital gains distributions. Profits on the sale of securities after deducting any losses, typically paid annually.

Distributions lower a fund’s share price by the amount of the distribution.  Shareholders who reinvest their distributions will receive additional shares. Shareholders who receive distributions in cash must include the distribution as part of their investment's total return.

Mutual FundsDistributions


This chart shows the effect of a distribution on a fund's price and on the change in the account's shares and balance. Distributions typically occur in November and December. Defer large purchases near a distribution to avoid a tax liability.

  Price Shares Value
Balance Before Distribution $10.00 100 $1,000.00
Dividend $.50/share   $50.00
Long-Term Capital Gain $.75/share   $75.00
After Distribution $8.75 100 $875.00
Account Balance After Reinvestment* $8.75 114.286 $1,000.00

*The $125 distribution reinvested at $8.75 will purchase an additional 14.286 shares.

Taxes and Account Types

To encourage savings, legislators have created tax-advantaged accounts like 401ks and IRAs (Individual Retirement Accounts. To encourage investment in government projects, legislators have created tax-advantaged investments like municipal bonds.  Understanding these concepts will help you determine if tax-advantaged investments are right for you.

Employer retirement plans and traditional IRAs allow most individuals to invest earnings before taxed. Many employers will match a portion of your contributions to their retirement plan. Most financial planners suggest that you invest in these plans first to increase retirement contributions.

Tax-deferred accounts

Tax-deferred accounts allow investment gains to grow tax-free until the money is withdrawn. There are two types of tax-deferred accounts. First, are accounts funded with pre-tax income. These include employer retirement plans like 401Ks and IRAs. Second, are accounts funded with after-tax income. These include Roth IRAs and annuities.

Roth IRA accounts

Roth IRA accounts are funded with after-tax earnings, but investment returns are never taxed, not even when withdrawn.

Tax-free investments.

Interest on municipal bonds is exempt from federal taxes and may be exempt from state and local taxes. Capital gains are not exempt from taxes. These investments are not appropriate for tax-advantaged accounts.

Tax Considerations

Investment tax strategies are specific to an individual’s situation and tax laws regarding investment income can be complex. This information is general in nature and should not be used to make investment decisions. For more information and assistance tailored to your personal situation, consult a tax professional or visit the IRS website at www.irs.gov for more information.

Investment companies provide a tax statement of your dividend and capital gain distributions each year. For a taxable account, you will receive IRS Form 1099-DIV. Proceeds from a sale are reported to you and the IRS on Form 1099-B. And if you have distributions from a tax-deferred account such as an IRA, you will receive Form 1099-R.

Many fund companies provide year-end statements which are helpful in calculating your tax obligations and make much of your account information available to you online.