Investment tax planning for mutual funds involves utilizing the tax rules that may help enhance your after-tax return on mutual fund investments. To help enhance the return on your investment in mutual funds, it is important for you to know how to determine income or gain from mutual funds, how to calculate your capital gains tax liability, and when to buy or sell mutual funds.
How does a mutual fund generate earnings for investors?
Mutual funds can generate income and gain on their investment portfolios. Any earnings are then distributed to individual investors based on the number of shares they hold; an investor can use the earnings, reinvest them into the fund, or invest them elsewhere.
Regardless of what you do with those earnings, they are considered taxable (unless they represent interest from tax-exempt investments such as municipal bonds or are held in a tax-deferred account), and you may also incur a taxable gain (or loss) when you sell shares in the fund.
How do you determine income or gain from mutual funds?
Understanding how you are taxed is the first step to investment tax planning for mutual funds. To get a handle on this, you need to know how you can realize money or value from your investment. Basically, there are many ways that you can receive investment returns from a mutual fund:
- Dividend income distributions
- Tax-exempt interest distributions
- Capital gains distributions
- Capital gains (or losses) on mutual fund share sales
In general, your investment income and capital gains distributions are subject to federal taxation. (State laws vary, so you should check to see how your state taxes investment income.) Note that "distributions" refers to actual cash distributions or to reinvested earnings. You may not actually receive any money. You may, for instance, get additional shares of the mutual fund instead. The earnings of the mutual fund generally pass through to the shareholders.
Dividend income distributions
Qualifying dividends received by an individual shareholder from a domestic corporation or qualified foreign corporation are taxable at long-term capital gains tax rates. Mutual fund distributions that represent such dividends will, subject to an additional holding period requirement described below, also qualify for capital gains tax treatment. All other dividend distributions will be taxed at ordinary income tax rates.
Taxpayers may receive both types of dividends in a given year. The mutual fund company should indicate the amount of ordinary dividends and the amount of qualified dividends on Form 1099-DIV.
Special holding period requirements apply to mutual fund shareholders. For stock dividends to qualify for taxation at the long-term capital gains tax rates, the stock must generally be held for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. Mutual funds that hold dividend-paying stock and meet this requirement may pass through qualifying dividends to mutual fund shareholders. However, mutual fund shareholders must themselves hold their mutual fund shares for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date to be able to take advantage of the lower capital gains rates on the dividends that are passed through.
Here’s an example. You bought 10,000 shares of ABC Mutual Fund common stock on July 9, 2014. ABC Mutual Fund paid a cash dividend of 10 cents per share. The ex-dividend date was July 16, 2014. The ABC Mutual Fund advises you that the portion of the dividend eligible to be treated as qualified dividends equals 2 cents per share. Your Form 1099-DIV from ABC Mutual Fund shows total ordinary dividends of $1,000 and qualified dividends of $200. However, you sold the 10,000 shares on August 12, 2014. You have no qualified dividends from ABC Mutual Fund, because you held the ABC Mutual Fund stock for less than 61 days.
Tax-exempt interest distributions
A mutual fund can earn tax-exempt income (exempt from federal and possibly state income tax) if the interest is generated by municipal bonds. If the income is generated from U.S. Treasury securities, it will be exempt from state income taxes only. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The type of securities held by the mutual fund will determine the type of tax (state or federal) from which you may be exempt.
Capital gains distributions
A mutual fund makes a capital gains distribution when it makes a distribution out of its net realized long-term capital gains (for instance, when it distributes profits from the sale of its investments held longer than one year). You must pay tax on these distributions at the applicable long-term capital gains tax rates (discussed later). You may also be required to pay tax at long-term capital gains tax rates on the fund's realized but undistributed long-term capital gains.
Some mutual funds invest in foreign securities or other instruments. Your mutual fund may choose to allow you to claim a deduction or credit for the taxes it paid to a foreign country or U.S. possession. The fund will notify you if this applies to you. The notice will include your share of the foreign taxes paid to each country or possession and the part of the distribution derived from sources in each country or possession.
You may be able to claim a credit for income taxes paid to a foreign country. However, it may be to your benefit to treat the tax as an itemized deduction on Schedule A (Form 1040). Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility.
Capital gains (or losses) on mutual fund share sales
A share of a mutual fund is considered a capital asset. When you realize net gains on the sale of capital assets held for over one year, you are subject to tax at long-term capital gains tax rates. Generally, the gain or loss is the difference between what you paid for the shares of the mutual fund and the amount you received when you sold such shares. Note that there are some special tax basis rules relating to mutual funds. You need to know these rules to calculate your gain (discussed later).
Essentially, your capital gain (or loss) on the sale of mutual fund shares equals the profit (or loss) you make from the sale of your investment in the fund (i.e., the sales price or amount realized from the sale minus your adjusted tax basis). However, tracking the tax basis of your mutual fund shares can get a bit involved, so accurate record keeping is important. In order to track your adjusted tax basis in your mutual fund shares, you will need to know: (1) when your mutual fund tax basis must be adjusted, and (2) how to calculate tax basis when you sell only some of your mutual fund shares.
As a holder of mutual fund shares, there are certain instances when your tax basis in your shares must be adjusted. In particular, dividends and capital gains distributions that are reinvested may warrant basis adjustments. Reinvestment plans allow you to reinvest dividends and capital gains distributions in new mutual funds shares instead of receiving cash; the distributions are reported as if you had received them in cash.
However, the basis of your mutual fund account is adjusted upward for the amount reinvested. The reinvested distributions are considered your cost basis for the newly acquired shares. So, if you reinvest distributions, your basis in the new shares will equal your taxable distribution divided by the number of new shares received. The basis of your mutual fund shares will increase by the reinvested distribution amount.
Here's an example. Assume that your mutual fund generates $10 worth of taxable earnings that has been reinvested; two additional mutual fund shares have been issued to you. Your basis in the new shares is $5 each, while your basis in the old shares remains the same. (Your basis for all of your mutual fund shares is increased by the $10 worth of reinvested earnings.)
Calculating gains or losses when you don't sell all your shares
When you sell less than all of your shares in a mutual fund, it may be necessary to determine which shares were sold if all of your shares don't have the same holding period and/or adjusted tax basis.
The general capital gains rules require that you use the specific identification method, the first in, first out (FIFO) rule, or the average cost method to determine basis in partial sales. Basically, the specific identification method lets you pick and choose which securities to sell (assuming you can identify them and use their specific bases). If you use the specific identification method, you must be able to (1) specify to your broker or other agent the particular shares to be sold or transferred at the time of the sale or transfer, and (2) receive confirmation of your specification from your broker in writing within a reasonable time. The FIFO method requires you to treat the first share purchased as the first sold. This may be beneficial from a long-term capital gains perspective, but it may have negative consequences in terms of tax basis if the market value of your shares has risen over time. The average cost method allows you to average your total cost basis among the number of shares you own.
You can use the specific identification method or the first-in first-out method only if you did not previously use the average cost method for a sale, exchange, or redemption of other shares in the same mutual fund.
If you receive a capital gains distribution and sell the shares at a loss after holding them for six months or less, you must treat this loss as a long-term capital loss. If you received tax-exempt interest on mutual fund shares that you held for six months or less and sold at a loss, you may claim only the portion of the loss that exceeds the amount of the tax-exempt interest.
When you'll need to report distributions
You generally include mutual fund distributions for tax purposes in the year received. However, distributions declared in the last quarter of the year but not paid until January of the following year will generally be included in your income in the year declared (even if not distributed).
Timing your purchases and sales
A mutual fund may have realized capital gains but not yet distributed these amounts to the shareholders. Prior to the record date of the distribution, the share prices should reflect this added value. Likewise, once these amounts are paid, the share value should decrease. If you purchase shares prior to the record date, you will receive a taxable distribution and your share price should decline accordingly. You have effectively accelerated your tax liability. From a tax standpoint (but not necessarily an investment standpoint), it may be more prudent to wait to purchase until after the record date.
Of course, if you can sell just prior to the record date, you may have the opportunity to convert a short-term capital gain (treated as an ordinary income distribution) into a long-term capital gain: Since the fund's basis and holding period in its investments are used to determine whether distributions from the fund are treated as capital gains distributions, but your own basis and holding period in your mutual fund shares are used to determine the tax treatment of any gain on the sale of your mutual fund shares, you may have the opportunity to convert short-term gain into long-term gain (with the potential for tax savings of up to 20 percent of the distribution).
Year-end tax planning
Year-end strategies, in part, take timing factors into consideration. You may want to recognize or avoid recognizing certain gains or income at the end of the year in light of your personal situation (i.e., the availability of capital or ordinary losses, or your tax bracket). There may be a good reason to increase your receipt of taxable income and gain.
Of course, most year-end strategies focus on deferring taxation until the next year. This is generally accomplished by selling depreciated or declining investments in the earlier year, while deferring the sale of appreciated or rising investments. Given the diversity of mutual fund investments that are available, the proceeds from the earlier sales can be immediately reinvested in similar investments. (However, if you reinvest the sales proceeds within 30 days before or after the sale in substantially identical mutual fund shares, any loss on the sale may be disallowed under the wash sale rules.)
If you have realized capital gains from selling securities at a profit and you have no tax losses carried forward from previous years, you can sell losing positions to avoid being taxed on some or all of those gains. Any losses over and above the amount of your gains can be used to offset up to $3,000 of ordinary income ($1,500 for a married person filing separately) or carried forward to reduce your taxes in future years. Selling losing positions for the tax benefit they could provide is a common financial practice known as "harvesting your losses."
Here's an example. Harry sold shares of ABC Mutual Fund this year for $2,500 more than he paid when he bought the shares four years ago. He now decides to sell the XYZ Mutual Fund that he bought six years ago because it seems unlikely to regain the $20,000 he paid for it. He sold his XYZ shares at a $7,000 loss. He offset his $2,500 capital gain in the ABC fund, as well as $3,000 of ordinary income tax this year. He also can carry forward the remaining $1,500 to be applied in future tax years.
To engage in proper investment tax planning, you must have a clear understanding of your own tax situation--your tax bracket, the holding periods and bases of your investments, and the availability of ordinary and capital losses. One of the first decisions you must make when engaging in tax planning is whether you prefer ordinary income or capital gain income (generally, capital gain is preferable, but not always).
Once you've determined the type of income you prefer, you need to consider the various investment vehicles available. And if you decide to invest in mutual funds, it is important to include your tax situation as a factor when evaluating the various types of funds. Your financial advisor and accountant can help you understand these issues.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer or professional tax advisor and a financial advisor.
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Dan Flanagan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com
Mutual funds are not guaranteed or insured by the FDIC or any government agency, and your shares may be worth more or less than you paid when you sell them. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund's performance. Before investing in a mutual fund, carefully consider the investment objectives, risks, charges, and expenses of the fund. This information can be found in the prospectus, which can be obtained from the fund. Read it carefully before investing.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2021. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.