The 7 Tax Rules Of Mutual Funds

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This article appeared on Liberty Investor™.

Mutual funds seem easy, and most investors believe they understand funds. But the income tax rules for funds are more involved than many people realize. Knowing the nuances of the rules is important. Taking different actions or changing their timing could improve your after-tax returns by a significant amount and preserve more of your nest egg.

Let’s take a quick trip through some key parts of the tax code to learn ways to increase your after-tax returns from mutual funds. Of course, what we’re going to discuss in this visit applies to mutual funds held in taxable accounts, not to funds held in qualified retirement plans, such as 401(k)s, traditional individual retirement accounts and Roth IRAs.

The basic rule to understand is a mutual fund itself generally isn’t taxed on its income or gains. To avoid taxes, each year a mutual fund has to pay out and pass through to its shareholders most of its net interest, dividends and capital gains. You as the shareholder are taxed on your share of these items.

While this rule prevents double taxation of the investment returns, it sometimes causes problems. Your share of the income is determined by your ownership on the day the distribution is made. That results in the inequity of a shareholder purchasing shares of a mutual fund the day before a distribution and being taxed on the full amount of the distribution.

Example: Max Profits buys 1,000 shares of a mutual fund on Dec. 29 for $15 per share. On Dec. 30, the fund makes its annual distribution of net capital gains and dividends realized for the year, amounting to $5 per share. This reduces the value of Profits’ shares by $5. He also has to include the $5 in his income for the year, though in his case it really is a return of his investment.

No. 1: Don’t invest in a fund just before a distribution.

Most funds indicate their scheduled distribution dates on their websites and to anyone who calls and asks. You need to be especially wary of making investments near the end of the calendar year and each calendar quarter. Income funds, such as bond funds, tend to make distributions at the end of each month.

When you are caught in this situation, an option is to sell the fund shares right after the distribution. In the example, Profits’ tax basis in the shares still will be his purchase price of $15 per share, and their net asset value after the distribution will be $10. He can sell right away and have a $5 loss. Of course, this isn’t a perfect solution. There might be transaction costs if he invested through a broker, and the fund might have a redemption fee for short-term holders. Plus, there’s the value of Profits’ time.

Also, under the wash sale rules, Profits can’t immediately buy back the fund shares if he wants to deduct the loss. He has to wait more than 30 days. In that time, the fund’s share price might have moved significantly higher.

Avoid these problems. Avoid month-end fund purchases and check a fund’s distribution schedule before making a purchase.

Buying the wrong mutual funds can prevent you from receiving the full benefit of tax-deferred compounding of investment returns. This is another effect of the way a fund passes through income and gains to shareholders.

Before choosing a fund, you should examine the turnover rate, or the rate at which it buys and sells investments. A fund with 100 percent turnover sells its entire portfolio and purchases other investments within a year.

The turnover rate is important because a fund distributes only its realized capital gains and other investment income. A stock fund with low turnover buys stocks and holds them for a long time, or at least longer than a year. As the stock appreciates, it is not selling the stock to realize the gains, and it doesn’t have to distribute its paper gains to shareholders. The fund shareholder can continue to own the fund shares, watch them appreciate and not have to pay taxes on the gains until he sells the fund shares.

But a fund with high turnover does a lot of buying and selling during the year. It realizes a lot of its capital gains and has to distribute them to shareholders. The shareholders have to include the distributed gains in their income for the year and lose the opportunity to let the gains compound tax-deferred.

Suppose two mutual funds have identical returns over time. But one is a low-turnover fund that makes few distributions to shareholders. The other is a high-turnover fund that distributes more than half its annual return to shareholders. After a few years, the shareholders in the low turnover fund will be much better off. Their gains compound without being reduced by taxes each year; and when they sell the fund shares, the gains will be taxed at favorable long-term capital gains rates.

Most published mutual fund returns generally are pre-tax. You can find after-tax returns for hypothetical shareholders in a fund’s prospectus and in some services and websites.

There’s another downside to high turnover funds. Most of their gains tend to be short-term capital gains, because they held the shares for one year or less. When a mutual fund has long-term capital gains that it distributes, shareholders report these as long-term capital gains on their tax returns. But a fund’s distributed short-term capital gains are reported as ordinary income on shareholders’ tax returns. They are taxed at the shareholder’s maximum marginal tax rate, plus they aren’t offset by any capital losses the shareholder has.

No. 2: Avoid funds that have high-turnover ratios or a history of distributing a high percentage of their annual returns.

If you must purchase such funds, do it through a tax-advantaged account such as an IRA.

For some people, the solution is to own only passive or index mutual funds. That’s generally a good solution, but it’s not foolproof. All index funds are not the same. While Vanguard and other mutual fund families work hard to keep expenses very low on their index funds, not all fund companies do. In addition, some funds track indexes not by purchasing the individual stocks but by using futures or options for at least part of their portfolios. These can create less favorable tax consequences.

No. 3: Examine index funds just as carefully as active funds before investing.

Check expenses, distribution histories and performance relative to the index. You’ll find a surprisingly wide variation, especially for indexes other than large company stock indexes such as the Standard & Poor’s 500 index.

When you’re a passive or index fund investor, you also should consider exchange-traded funds as well as traditional open-end mutual funds. Exchange-traded funds are able to use a few tricks to keep their expenses even lower than most open-end mutual funds. In addition, ETFs can use some tax strategies not available to open-end mutual funds.

No. 4: Compare open-end mutual funds and ETFs when considering an index or passive strategy.

Mutual funds don’t pass through their realized losses. When a fund sells an investment at a loss, the loss can offset gains realized during the year and reduce the gains passed through to shareholders. A good fund manager takes this into consideration and will look for losses in its portfolio that can be taken to offset any gains it realizes. When a fund’s losses exceed its gains during the year, as happened to most funds during 2008, the losses are carried forward and can offset future gains. That can enhance the attractiveness of a fund that’s been down. It might be a value and a turnaround opportunity, plus it could have carryforward losses to offset future gains.

No. 5: Check the prospectus for loss carryforwards.

Reinvesting fund distributions makes life easy, at first, but creates problems later. Shareholders still are taxed on the distributions, even if they don’t receive the cash. But that’s not the real problem.

Each time a distribution is reinvested, your basis in the new shares is their value on that date. Most people go for years holding a fund and reinvesting distributions. They have a bunch of shares bought at different times and different prices. When they’re ready to make partial sales of their holdings to fund retirement, they have a complicated tax picture. They have to determine the tax basis and holding period of the shares sold.

No. 6: Avoid automatic reinvestment of distributions.

Instead, let distributions accumulate in a money market fund. Then, use the account to rebalance your portfolio by purchasing new shares in funds that have lagged the others.

When you sell fund shares, you need to know three things: the net sale price, the tax basis and the holding period. Finding the last two items can be difficult when you’ve owned a fund for years, made a series of investments and had distributions reinvested.

The Internal Revenue Service issued regulations in 2008 to make this easier. The fund family or broker has to report your cost basis and whether the gain is long-term or short-term. But the calculations are required only for mutual funds purchased in 2012 and later years. Some funds voluntarily report the amounts for shares purchased in earlier years. Also, the fund family or broker can choose how to compute the cost basis, and most use the average cost method.

But you can choose another method to compute the basis for your sale. For example, you can specifically identify the shares being sold. That allows you to choose the shares that have the highest basis and, therefore, the lowest capital gain. Or if you have a capital loss, you can choose the shares with the highest capital gain so that it is offset by the loss.

But to change the cost basis that is reported, you have to notify the broker or mutual fund in writing before the sale. The financial firm chooses the format in which you have to make the writing.

No. 7: Plan your sales.

When you’re selling a portion of your holdings, you can choose which shares are being sold in order to achieve the best tax results. But you have to work with the broker or mutual fund firm to ensure the firm reports the basis you want.

When the broker or fund issues the Form 1099 after the year, review it carefully right away. Your tax return has to match it. If the form is incorrect, you have to notify the financial firm and have a corrected version issued.

Bob Carlson

is editor of the monthly newsletter and web site, Retirement Watch. Carlson is Chairman of the Board of Trustees of the Fairfax County Employees' Retirement System, which has over $3 billion in assets, and was a member of the Board of Trustees of the Virginia Retirement System, which oversaw $42 billion in assets, from 2001-2005. He was appointed to the Virginia Retirement System Deferred Compensation Plans Advisory Committee in 2011.His latest book is Personal Finance for Seniors for Dummies, published by John Wiley & Co. in 2010 (with Eric Tyson). Previous books include Invest Like a Fox... Not Like a Hedgehog, published by John Wiley & Co. in 2007, and The New Rules of Retirement, as published by John Wiley & Co. in the fall of 2004. He has written numerous other books and reports, including Tax Wise Money Strategies, Retirement Tax Guide, How to Slash Your Mutual Fund Taxes, Bob Carlson's Estate Planning Files, and 199 Loopholes That Survived tax Reform. He also has been interviewed by or quoted in numerous publications, including The Wall Street Journal, Reader's Digest, Barron's, AARP Bulletin, Money, Worth, Kiplinger's Personal Finance, the Washington Post, and many others. He has appeared on national television and on a number of radio programs. He is past editor of Tax Wise Money. Carlson is an attorney and passed the CPA Exam. He received his J.D. and an M.S. (Accounting) from the University of Virginia and received his B.S. (Financial Management) from Clemson University. He also is an instrument rated private pilot. He is listed in several recent editions of Who's Who in America and Who's Who in the World.

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