Tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the fund’s portfolio of securities and you must report as income any mutual fund distributions, whether or not they are reinvested.
All dividends and interest from securities in the portfolio, as well as any capital gains from the sales of securities, are taxed to the shareholders.
Whether you’re new to mutual funds or a seasoned investor who wants to learn more, these tips will help you avoid the tax bite on mutual fund investments.
First, you need to understand how distributions from mutual funds are taxed. There are two types of taxable distributions: ordinary dividends and capital gain distributions.
Ordinary Dividends. Distributions of ordinary dividends, which come from the interest and dividends earned by securities in the fund’s portfolio, represent the net earnings of the fund,. They are paid out periodically to shareholders.
In 2017 (same as 2016), dividend income that falls in the highest tax bracket (39.6%) is taxed at 20 percent. For the middle tax brackets (25-35%) the dividend tax rate is 15 percent, and for the two lower ordinary income tax brackets of 10% and 15%, the dividend tax rate is zero.
Qualified dividends. Qualified dividends are ordinary dividends that are subject to the same the zero or 15 percent maximum tax rate that applies to net capital gain. They are subject to the 15 percent rate if the regular tax rate that would apply is 25 percent or higher; however, the highest tax bracket 39.6%, is taxed at a 20 percent rate that would apply is lower than 25 percent, qualified dividends are subject to the zero percent rate.
Dividends from foreign corporations are qualified where their stock of ADRs (American depositary receipts) are traded on U.S. exchanges or with IRS approval where U.S. tax treaties cover the dividends.
Capital gain distributions. When gains from the fund’s sales of securities exceed losses, they are distributed to shareholders. As with ordinary dividends, these capital gain distributions vary in amount from year to year.
A mutual fund owner may also have capital gains from selling mutual fund shares.
Capital gain rates. The beneficial long-term capital gains rates on sales of mutual fund shares apply only to profits on shares held more than a year before sale. Profit on shares held a year of less before sale is considered ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.
Medicare Tax. Starting with tax year 2013, and additional Medicare tax of 3.8 percent is applied to net investment income for individuals with modified adjusted gross income above $200,000 (single-filers) and $250,000 (joint filers).
Minimizing Tax Liability on Mutual Fund Activities
Now that you have a better understand of how mutual funds are taxed, here are seven tips for minimizing the tax on your mutual fund activities.
1. Keep Track of Reinvested Dividends.
Most funds offer you the option of having dividend and capital gain distributions automatically reinvested in the fund-a good way to by new shares and expand your holdings.
2. Be Aware That Exchanges of Shares Are Taxable Events
The “exchange privilege,” or the ability to exchange shares of one und for shares of another, is a popular feature of many mutual fund “families,” i.e., fund organizations that offer a variety of funds. For tax purposes, exchanges are treated as if you had sold your shares in one fund and used the cast to purchase shares in another fund.
3. Do Not Overlook the Advantages of Tax-Exempt Funds
If you are in the higher tax brackets and are seeing investment profits taxed away, then there is a good alternative to consider: tax-exempt mutual funds.
Your tax-exempt mutual fund will send you a statement summarizing its distributions for the past year and explaining how to handle tax-exempt dividends on the state-by-state basis.
4. Keep Records of Your Mutual Fund Transactions
It is crucial to keep the statements from each mutual fund you own, especially the year-end statements.
By law, mutual funds must send you a record of every transaction in your account, including reinvestments and exchanges of shares. The statement shows, the date, amount, and number of full and fractional shares bought or sold. These transactions are also contained in the year-end statement.
Why is recordkeeping so important?
When you sell mutual fund shares, you realized a capital gain or loss in the year the shares are sold. You must pay tax on any capital gain arising from the sale, just as your world from a sale of individual securities.
Re-investing Dividends & Capital Gain Distributions when Calculating
Make sure that you do not pay any unnecessary capital gain taxes on the sale of mutual fund shares because you forgot about reinvested amounts.
Failure to include reinvested dividends and capital gain distributions in your cost basis is a costly mistake.
Don’t Overlook Possible Tax Credits for Foreign Income
If your fund invests in foreign stocks or bonds, part of the income it distributes may have been subject to foreign tax withholding. If so, you may be entitled to a tax deduction or credit for your pro-rata share of taxes paid. Your fund will provide you with the necessary information.
If you have any questions about the tax treatment of mutual funds, please call. Detailed guides outlining subject matter such as Life Events, Business Strategies, Investment Strategies, Tax Strategies and the answers to 500 every day financial questions can be found free at http://savemyretirement.com
For the past 16 years Todd Hickman has co-hosted a weekly financial radio show on NewsTalk 560AM KLVI, airing each Sunday at 11AM. You can reach Todd during the week at 409-840-6900 or by visiting his company’s website at http://savemyretirement.com.