How Capital Gains Work

Investors in mutual funds can be taxed on both the income a fund makes while you own its shares -- known as capital gains -- and on the profits you make when you exchange or sell shares.

Capital gains can be defined as the difference between an asset's purchase price and selling price, when the difference is positive. (A capital loss would be when the difference between an asset's purchase price and selling price is negative.) Gains come in two forms, unrealized and realized:

Unrealized gains are gains on paper only and aren't taxed until the gains are realized and distributed to shareholders. A fund can post a large return and not trigger taxes for its shareholders if the securities in which it invests appreciate and are not sold.

Realized gains occur when an asset that has appreciated in value is sold. At that point, the profit is taxable as a capital gain. Portfolio managers can offset profits from the sale of one stock with losses from the sale of another stock, a balancing act that reduces the net taxable gain.  However, if the performance of the new stocks is disappointing, the investors can be faced with paying taxes on capital gains.

There are also two basic categories of capital gains:  short-term in which the assets are held one year or less and long term:  assets held longer than 12 months.  Short-term gains are taxed at your ordinary income tax rate. The maximum tax rate on most long-term capital gains for people in the two lowest tax brackets is 5%, for all other taxpayers, the maximum tax rate is 15%. Beginning in 2008, the long-term capital gain tax rate will drop to zero for most taxpayers in the two lowest brackets.

If you're concerned about the tax consequences of the funds you own, you may want to consider greater participation in growth stock funds. The reason: by nature, such funds keep taxable gains to a minimum through their buying and selling strategies. Also, equities in general now may be even more attractive than bonds from a tax standpoint. Bond interest is still taxable as ordinary income. Look for stock funds with low turnover rates because they hold stocks longer, ensuring more favorable long-term gains.

The tables below outline the current tax brackets and capital gains rates for investors.

Note:

• A mutual fund company is required to distribute to its investors any income that exceeds losses.
• You may elect to receive fund distributions in cash or reinvest them in additional shares. However, distributions are taxable, regardless of whether they are paid in cash or reinvested. They must be reported in the year the money is distributed to you.
• Mutual funds held in tax-deferred accounts such as 401(k) plans, IRAs, or variable annuities are not subject to annual taxes. Only the withdrawals are subject to tax.

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