Wealth accumulated through mutual fund investing triggers taxation like any other investment. The more you understand where the tax obligations come from, the more you can factor those costs into a long-term investment strategy.
Four X-factors of mutual funds and taxes
The more you know about how mutual funds are taxed, the more control you’ll have over your obligations. These are some questions investors have when it comes to what they owe.
What's taxable?
The type of account you own plays a big factor in what becomes taxable each year. Generally, retirement accounts allow for tax-deferred growth and are taxed only when you decide to withdraw assets. Qualified Roth IRA withdrawals are generally tax-free. For taxable non-retirement accounts, fund distributions are also subject to taxation. And the distributions you receive from mutual fund investments come in four types.
Ordinary income (ordinary dividends)
Ordinary income is the sum of the fund's net investment income and net short-term capital gains. Net investment income generally refers to dividends and interest paid from the securities held in the fund, minus expenses. Short-term capital gains can be generated when the fund sells a security and realizes a gain. If the security that was sold was held in the fund for 12 months or less, the fund's gain or loss is considered short-term and the gains are treated as ordinary income.
Qualified dividends
Qualified dividends are generally taxed at a long-term and typically lower capital gain rate. This is provided that certain holding period and other requirements are satisfied. Qualified dividends are derived from one of the following:
- Stock of a domestic company
- Foreign securities readily traded on established U.S. securities markets
- Foreign securities that have a comprehensive tax treaty with the U.S.
Capital gain distributions
When a mutual fund sells a security in its portfolio, it generally realizes a gain or loss. If the fund held the security for more than 12 months, the gain or loss is considered long-term. Generally, any gains are passed through to the shareholders of the fund each year in the form of a capital gain distribution and the owners of the fund will owe taxes on the distribution for the year in which the distribution occurred. Typically, this is taxed at the long-term capital gain rate, which is lower than the ordinary income rate.
Non-dividend distributions (Return of Capital)
Return of Capital is a nontaxable distribution from a fund not attributable to the fund's earnings. It generally occurs when a fund's distributions during a fiscal year exceed current earnings and profits as defined in IRS regulations for mutual funds. Fund distributions are paid based on earnings as defined by Securities and Exchange Commission (SEC) accounting standards, which may differ from how the IRS defines earnings. A return of capital may be caused by a "temporary" difference between a fund's book earnings (SEC accounting) and earnings for IRS purposes. This information is reported to you on Form 1099-DIV.
What events trigger taxation?
Whenever you sell shares in a mutual fund, whether by redeeming or exchanging, you have triggered a taxable event, unless the exchange occurred within a tax-deferred retirement plan. Below are the events that Janus Henderson reports to the IRS.
Buying
Though an investor would not pay taxes at the time of a buy, the buy itself needs to be documented. The purchase price is used to establish a cost basis for a taxable non-retirement account and to calculate a net gain or loss when the fund shares are sold in the future. For retirement accounts such as an IRA, the purchase is reported to the IRS because there are limits to how much can be contributed to these types of accounts and tracking is necessary. For IRA accounts, this generally shows up on Form 5498.
Selling
There are two types of outcomes that could influence your tax obligation:
Capital Gains
The length of time shares have been owned affects how any gains from a sale are taxed:
- If shares were purchased and held for more than a year before the sale, it's generally considered a long-term capital gain. Long-term gains typically receive more favorable tax treatment than short-term gains.
- Gains from the sale of fund shares held for one year or less are taxed as short-term gains. These gains are generally taxed at ordinary income tax rates.
Capital Losses
If you sell mutual fund shares for a loss, you may be able to use that loss to offset other capital gains on your tax return. You may deduct up to $3,000 annually. Short-term capital gain distributions from mutual funds may not be used to offset other capital losses.
Generally, any remaining personal capital losses you have from one tax year may be used in future years to offset capital gains. Refer to IRS Publication 550 or your tax advisor for more information.
What Happens if you Exchange One Fund For Another? Is That A Taxable Event?
Many investors think of a mutual fund exchange as simply trading shares of one fund for another. When you exchange fund shares in a taxable account, you are actually selling the shares of one fund and using those proceeds to purchase the shares of the other fund. As a result, the exchange will have tax consequences if you have a gain or loss in the fund that you are selling. An exchange between funds within your retirement account does not create a taxable event.
What do I need to know about cost basis?
What is cost basis?
At its simplest, it’s the amount of money on which you have already paid taxes. Tax obligations are calculated by subtracting the basis from the sale price. If shares were sold at a loss, the cost basis would be higher than the amount of the redemption. If the cost basis is lower than the amount of the redemption, the shares were sold at a gain.
Stay aware
Cost basis accounting is useful for many taxable situations, including, for example, when dividend payouts are reinvested. This reinvestment raises the price-per-share of the purchase, which must be accounted for in your taxes.
The more you understand cost basis accounting, the more you’ll truly understand your taxes.
Go to Understanding Cost Basis.
What should I know about mutual fund income?
What are other forms of income?
Mutual funds may pay periodic distributions that are derived from income-producing securities held in the fund in the form of dividends and interest payments. They also come from the gains generated from the sale of securities.
Questions? Contact a tax advisor for specifics about your tax requirements.
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