Tax implications can be dauntingly complicated for investors in taxable mutual funds. Understanding their after-tax returns is crucial in making smart investment choices.
Organising your taxes correctly can be time consuming and painstaking for even experienced investors, but with some prep and careful record-keeping it doesn’t need to be stressful or time consuming.
Dividends
Mutual funds are an increasingly popular investment vehicle among millions of investors, providing an easy and straightforward way to diversify assets without picking individual stocks and bonds individually. Dividends and capital gains of mutual funds are taxed just like other income, with shareholders subject to IRS taxes on the difference between their adjusted cost basis and purchase price for shares purchased at auction; long-term investments tend to incur lower tax rates compared with shorter investments; as the tax rates for ordinary dividends or capital gains distributions depend on how long their shares have been owned by shareholders.
At the end of each year, mutual funds distribute any taxable dividends or net realized capital gains they have accrued during that year to their investors. If investing through taxable accounts, investors must include this distribution as income on their tax returns even if reinvested back into additional shares instead. When using tax-advantaged accounts like an IRA or 401(k), however, any tax liability for these distributions are avoided immediately upon receipt.
Capital gains are realized when funds sell investments at higher prices than they cost to purchase them, or when profits from such sales exceed costs incurred to acquire them. A fund may choose to keep these profits rather than distribute them among shareholders immediately, however these undistributed gains remain taxable when distributed eventually – as such shareholders will receive an IRS Form 1099-DIV in January outlining your share of these capital gains.
Mutual funds may generate both capital gains and ordinary dividends, with ordinary dividends taxed at the same rate as interest from Treasury bills and bonds. Funds may also offer qualified dividends which are taxed at a reduced rate; such income typically comes from foreign corporations trading on U.S. exchanges or approved by the IRS.
Capital Gains
Mutual funds offer investors an efficient way to diversify their investments. But it’s essential that investors understand when and how much taxes must be paid on mutual fund holdings – in addition to dividends and interest payments, capital gains taxes also need to be reported; how much you owe depends on how long the fund has been owned as well as which tax bracket it falls into.
Mutual funds produce income by investing in stocks and bonds, but may also make profits trading other assets such as real estate, commodities or cash. Any profits earned through this trading are known as capital gains; they’re passed along to shareholders either via distributions or reinvested into additional shares of the fund. As a shareholder, you are responsible for paying capital gains taxes on any earnings regardless of whether your account is held through traditional brokerage account or tax-advantaged retirement such as an IRA.
Capital gains taxes paid to mutual funds are calculated using an adjusted cost basis method, which takes into account both your original purchase price and any gains or losses realized from each investment. Your tax rate determines if short- or long-term capital gains rates apply depending on which category your account falls into.
Mutual funds are often actively managed, meaning their managers regularly trade assets to generate profits that lead to an increase in value of shares, with these profits then passed along as annual distributions, according to Dennehy. How much you owe will depend on whether or not you qualify for either the lower long-term capital gain rate or the higher ordinary income tax rate.
If this applies to you, long-term capital gains will incur the maximum federal income tax rate of 20% and may also incur 3.8% Medicare surtax or state income taxes on these profits.
To minimize your tax liabilities, invest in mutual funds with low turnover rates that invest in long-term assets like real estate or use an automated online investment platform such as SoFi Invest to facilitate keeping track of these documents.
Embedded Gains
Mutual fund gains can be a serious drain on investor capital, since, unlike individual securities, mutual funds do not pay taxes on capital gains until they sell and distribute those gains to shareholders; then these distributions are taxed as ordinary income rather than at the lower capital gains rate – an important distinction that many investors fail to consider when investing.
Typically, profits from selling investment assets are taxed at either long-term or short-term capital gains rates depending on how much was invested and for how long. For instance, short-term investors who purchase equity-oriented funds within 12 months will likely face higher tax rates while those holding them longer than this will generally qualify for long-term capital gains rates which tend to be lower.
So it is vital for you to keep accurate records of purchases and sales of fund shares. Fund companies provide shareholders with all of the records necessary, such as account statements as well as copies of IRS Form 1099 for each of their accounts.
Calculating taxes requires keeping accurate records, since knowing the cost basis of investments will allow you to determine your owed taxes after selling them. Some funds allow shareholders to choose between single-category averaging or double-category averaging methods of recording cost basis; choose what works for you most as this cannot be changed without permission from the IRS.
One way to mitigate embedded gains is investing in a tax-managed mutual fund. Such funds are designed to minimize capital gain distributions by harvesting losses to offset gains and limiting annual capital gain distributions; further minimizing their effect. Many also have lower turnover rates than non-tax managed funds which helps lessen embedded gains’ impact.
Offsetting Gains
Mutual fund managers make money from selling securities in their portfolio, and the IRS taxes any gains passed along to shareholders as dividends or distributions from funds. You will be sent IRS Form 1099-DIV outlining your portion of these gains, and must report it on your tax return.
Capital gains depend on how much you paid for each share, with most investors purchasing multiple purchases over time, meaning their cost basis could have changed due to sales loads charged by fund companies which will reduce total purchase price but add them back onto sale proceeds for tax purposes.
If you purchase a fund with a front-end sales load of 5%, when calculating your average cost basis you must add that amount to the purchase price to account for any future capital gains and any sales taxes due.
To calculate your per-share cost basis, it is crucial that you keep accurate records of all purchases and sales of shares from a fund. Your fund should provide these records, which should always be used when calculating capital gains and losses. These records include periodic account statements as well as copies of IRS Form 1099s; should any year pass where these aren’t provided you should reach out directly to them for replacement records.
Hold on to your mutual fund shares for an extended period, as the longer they are held the lower your capital gains taxes will be. Therefore, whenever possible it would be prudent to avoid selling fund shares in less than a year.
If you sell fund shares at a loss and then immediately buy more shares from the same or substantially identical mutual fund, applicable tax law treats this transaction as a wash sale and disallows your loss. To prevent this from occurring, take steps such as waiting 30 days before or after making any purchases in such funds to prevent this scenario from playing out.
