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If there's one ugly aspect of mutual fund ownership, it's the complicated, and sometimes expensive, tax situation this pooled investment product presents for its shareholders every year.
Uncle Sam's long arms can be an eye-opener for new mutual fund shareholders. If you own individual stocks, you're in charge of deciding when to sell your stocks and trigger a taxable event based on your call; but if you're a shareholder of a mutual fund, that power is out of your hands.
Mutual funds are conduits and by law must distribute all dividend and interest income as well as net realized capital gains to their shareholders each year. Unless your fund investment is part of a qualified retirement plan-like an IRA, 401(k) or Keogh account, in which taxes are deferred until a later date-each year that you're a shareholder in a fund, you're likely to incur some tax consequences. To be a tax-savvy mutual fund investor, here's what you must know about taxes and mutual funds:
Know where the tax liability comes from. There are three forms of distributions that spark tax payments:
1. Capital gains occur in a mutual fund's portfolio when a security, whether it be a stock or a bond, is sold at a price higher than what it was purchased at.
2. Dividends come from dividend-paying stocks. Well-established companies are more likely to pay dividends to shareholders than small companies are.
3. Interest is the amount earned on cash investments or any fixed-income securities held in a fund's portfolio.
Funds lump together any capital gains, dividends and interest income they kick off. That pay-out is called a distribution.
Distributions happen annually. If you're a shareholder of a fund on its "record date"-the date that determines who the share-holders of the fund are and whether they're eligible to receive its distributions-you're subject to its tax consequence.
If you intend to keep your fund investment in your personal account, as opposed to a tax-deferred one, it's worth your time to ask the fund family, or your investment advisor, when the fund's record date is, when its distribution date is and about any realized gains in the fund's portfolio. If the distribution date is near the date you'd planned to purchase your fund, you might want to delay getting those shares until after the fund's record date. That way, you'll avoid what's called "buying the distribution" and not be subject to a tax on an investment you've only owned for a very short period of time.
Avoid the puddle. Virtually every investment has a tax consequence sooner or later, but some funds have more advantages than others. For example, tax-managed mutual funds are organized to keep capital gains at a minimum; funds with high portfolio turnover rates are likely to generate more capital gains than funds with lower turnover rates; and small-cap stocks have a tendency to realize more capital gains but lower dividend income than large-cap ones.
Take record-keeping seriously. Every time you purchase or redeem shares of a mutual fund, you trigger some kind of taxable event. Come tax season, the only way to make sure you don't overpay, or underpay, Uncle Sam is to keep good records.
The best tax-conscious investment strategy for both portfolio managers and individual mutual fund shareholders is often a buy-and-hold one, and that means for at least one year. That way, any capital gains taxes incurred will be taxed at a 10 or 20 percent rate. Short-term holdings (those held for less than one year) are taxed as ordinary income at marginal rates that range from 15 to 39.6 percent. Ouch!
At a Glance
Taxes are as much a part of the investment arena as making money is. Keeping these points in mind may help ease the pain:
- To defer paying taxes on your mutual fund investments until a later date, open a qualified retirement account, like an IRA, SEP-IRA, Keogh or Roth IRA.
- The form needed to report dividend, interest and capital gains distributions is Form 1099-DIV.
- According to Morningstar, the Chicago-based mutual fund research company, taxes can lower the total return on stock funds held in a taxable account by an average of 2 to 3 percent per year.
- Within a calendar year, writing checks against your mutual fund account, trading or exchanging funds or redeeming any number of fund shares all bring on tax consequences.
Dian Vujovich is a nationally syndicated mutual fund columnist and author of 101 Mutual Fund FAQs(Chandler House Press). For free educational mutual fund information, visit her Web site, www.diansfundfreebies.com.