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%. 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.
Some observations
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, that 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.
Summary
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. Finally,
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.
