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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.
Generally, owning 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.
The 2003 Tax Act reduced the maximum tax rate on qualifying dividends and long-term capital gains to 15%. For those in the 10% and 15% tax brackets, the tax rate is 0%. These preferential rates were extended with the tax law changes in 2010 and are now scheduled to expire at the end of 2012. Your mutual fund will provide the appropriate information on your Form 1099 identifying the portions of your distributions qualifying for this preferential treatment.
Interest income will continue to be taxed as ordinary income at rates up to 35%. 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 your records.