Taxes And Your Mutual Funds

When you sell shares in a mutual fund, whether by redeeming, exchanging or writing a check, you have created a taxable event. You must report any gain or loss on your taxes unless the transaction occurred in a tax-deferred retirement plan or a money market fund.

It is your responsibility to keep accurate records of your mutual fund transactions. You will need this information when you file your income taxes, since you must report any capital gains or losses you incur when you sell shares. Remember, an exchange is a purchase and a sale for tax purposes.

• If you reinvest dividends or capital gains distributions, you purchase additional mutual fund shares. Retain all records of such reinvestments, because the amount reinvested should be added to your cost basis.
  
• Keep confirmation statements from the mutual fund company which show complete information for each purchase, sale or exchange, including the date, the number of shares, price per share, dollar amount and any fees or commissions in each transaction.
  

Many fund companies provide year-end statements which are helpful in calculating your tax obligations; however it is still suggested that you retain all confirmations and records. It is best to keep your own records, so that you have them when you need them at tax time.

• The fund company provides you with a tax statement of your dividend and capital gains distributions for the year on Form 1099 DIV. Proceeds from a sale are reported on Form 1099B. You must report these on your taxes. Since the IRS receives a copy as well, you could pay a penalty if you neglect to report them.
  
• Tax laws regarding securities and investment income can be quite complex. This information provides a basic understanding of the issues. We suggest that you seek guidance from a qualified tax consultant, especially if you own many taxable investments.
  

Questions and Answers

Everyone wants to pay as little in taxes as possible. The questions and answers provided here will help you understand how your mutual funds generate taxable income and what you can do to minimize the taxes you pay.

A mutual fund is not taxed on the income or profits it gets from its investments as long as it passes those earnings along to all of its shareholders. The shareholders in the fund then pay any taxes due. You may be taxed on those earnings in two ways:

• On the earnings a fund makes while you own its shares, such as dividends and interest earned by the fund on its investments and gains realized by the fund from selling its investments at a profit.
  
  
• On the money you make when you sell any or all of your shares, such as gains realized when you redeem shares at a profit.

Mutual funds distribute two types of income to you:

• Ordinary Income. A mutual fund earns dividends, interest and other income on the securities in which it invests. After a fund deducts its expenses from the investment income, it distributes the remainder to you as a dividend. Short-term capital gains (on securities held by the fund for a year or less) are considered ordinary income.
  
  
• Capital Gains. When a mutual fund sells a security it has owned for more than 12 months (18 months after July 28, 1997), the result is a long-term capital gain or loss. Any profit is passed onto you as a capital gains distribution.
  

Married Couples can Increase Their IRA Contributions:
A new provision allows a spouse not covered by a retirement plan to make a deductible contribution even if his or her spouse is covered. Don't pass up a chance to sock more money away.

Greater Access to IRA monies: Beginning with distributions after Dec. 31, 1997, penalty-free distributions can be made from either conventional or Roth IRAs if used to fund a first-time home purchase (up to $10,000).

Also, the 15 percent excise tax on distributions in excess of $160,000, and the 15 percent estate tax on retirement accumulations over that amount has been repealed. Distributions taken after Dec. 31, 1996 are covered, as are excess accumulations for those dying after Dec. 31, 1996.

Keep in mind that while conventional IRA distributions for education and first-time home purchases won't be hit with a penalty, they'll still be taxable.

Unless your mutual fund is set up as an IRA, 401(k) or other tax-deferred program, you will have to report both kinds of income on your taxes for the year the money is distributed to you.

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.

How do I report to the IRS the distributions I receive from the fund?

• Ordinary income. Record ordinary dividends on IRS Form 1040, line 9. If the total of your dividend distributions exceeds $400, you also must complete Schedule B.
• Long-term capital gain distributions. Include the amount on IRS Form 1040, line 13. You may also need to complete Schedule D.

What happens when I sell my mutual fund shares?

The sale of your shares will generate a capital gain or loss that you must report to the IRS. To figure out your gain or loss, you have to know the amount you have invested in the shares, also known as your "cost basis."

What is "cost basis"?

Cost basis is the amount of money you have invested in your shares. It includes any sales charges or redemption fees you paid for the shares upon purchase or sale. It also includes any reinvested dividend or capital gain distributions that you used to purchase more shares.

What happens when I exchange my shares?

An exchange is considered a sale of shares in one fund and purchase of new shares in another, so two things occur. First, the sale of the original shares will result in either a capital gain or loss, depending upon your cost basis in the shares. Second, the amount you receive from the sale and reinvest in the new shares will give you a new cost basis.

What happens when I have my distributions reinvested to buy additional shares?

The distribution will result in taxable income that you must report to the IRS, unless you purchased your shares through an IRA or other tax-deferred investment. However, since you are reinvesting the money in more shares, the amount is added to your cost basis.

What do I need to know to calculate my cost basis?

Calculating cost basis starts with determining the purchase prices for all shares you own in a specific fund. To do this, you should keep complete records of:

• The date of each purchase, sale or exchange
  
• The number of shares bought or sold each time
  
• The price at which shares are bought or sold
  
• Total dollar amount of each transaction
  
• Any sales charges or redemption fees paid
  

Now do I calculate my cost basis once I have this information?

The IRS gives you a choice of four ways to figure cost basis:

• FIFO, or first-in,first-out
• Specific shares
• Average cost - single category
• Average cost - double category

Which one you choose is important, since each one will result in a different amount of tax owed. The IRS assumes that you use the FIFO method unless your specify one of the others.

What is the FIFO method?

FIFO stands for "first-in, first out." You assume that the shares you purchased first are the first ones sold. In the example below, an investor bought 500 shares at $10 each, then 13 months later, an additional 500 shares at $15 each. If the investor sold 500 shares at $20 each and assumed a FIFO cost basis, the gain would be $5,000 ($10,000 sales price less $5,000 original cost).

In this instance, using one of the other cost basis methods would have reduced the investor's tax liability.

How would the specific shares method work in this scenario?

This method lets you designate which shares you sell, giving you the most control over the amount of gain or loss you report. If the investor had chosen to sell the last 500 shares he purchased, the gain on the sale would have been only $2,500.

To use this method when filing your taxes, you'll need to identify in writing, in advance, the specific shares you are selling. Send your mutual fund company a written request indicating the number of shares to redeem, the date they were purchased and the purchase price.

What are the "average cost" methods?

As the name suggests, these methods take the total you paid for your shares and divide by the number of shares you own to arrive at an average cost per share. The "single-category" method considers all of your shares as one group, whether you have owned them for more than one year (or more than 18 months after July 28, 1997) or less (short-term).

For the investor in our example, using the single-category average cost basis approach would have resulted in a reportable gain of $3,750 ($10,000 sales price, less $6,250 cost basis).

To report the sale on his tax return, the investor has to determine whether his holding period is long-term or short-term. The IRS requires that this be decided on a first-in, first-out (FIFO) basis, so he would consider this a sale of the first 500 shares he bought January 1, 1996, for a long-term holding period and capital gain.

What distinguishes the double-category method?

With this approach, you separate your mutual shares into two categories: those you have owned longer than one year (long-term) and those you have owned one year or less (short-term). Then you average the cost of your holdings in each group. Finally, you may indicate to the IRS whether you sold shares from the short-term or long-term category and calculate your gain or loss based on the average cost for that group only.

Other than choosing my cost basis carefully, what can I do to control the tax obligation on my mutual fund assets?

You'll want to watch out for two potentially taxing situations:

• Be cautious about buying just before a fund makes a dividend distribution. Consider this possibility: You buy shares for $10.50 per share a few days or weeks before a fund pays out its accumulated interest, dividends and/or capital gains. The price of the shares has no time to rise before the fund makes a distribution of $0.50 per share. You now have $0.50 of your investment back, which isn't a problem in and of itself; you can always reinvest the money in more shares. However, you also owe taxes on that $0.50 per share because it was given back to you in the form of a distribution. To avoid this situation, check with the fund company about the timing and amount of anticipated distributions.
  
  
• Don't create a "wash sale."If you sell shares at a loss and buy additional shares in the same mutual fund 30 days before or after the sale, you can't claim the loss on your tax return until you sell the additional shares. In the IRS's view, buying the additional shares "washed out" your loss.

It is easy to inadvertently effect a wash sale when you own shares of the same fund in different accounts or if you reinvest dividends automatically and make frequent exchanges. The rules are complex, so you may want to consult a tax professional.

Is there any other way to reduce the tax impact?

• The most obvious way to minimize the current taxes on your mutual fund earnings is to invest through a tax-deferred account such as an IRA, SEP-IRA or other tax-qualified retirement plan. No taxes are due on any earnings (i.e., fund distributions) in these accounts until you withdraw the money. At withdrawal, you will owe ordinary income taxes on any portion of your withdrawal attributable to earnings. However, because all of your earnings remain in the account to generate more earnings, your investment may grow faster.
  
  
• If you are investing on a child's behalf, consider investing in the child's name. The tax laws give children a break. The first $650 of investment income earned is not taxable; the next $650 is taxable at the child's marginal tax rate (usually 15%). Once the child's investment income exceeds $1,300 in any given year, the excess will be taxable at your marginal tax rate. So, if you are investing on behalf of a minor, ask your fund company about a Uniform Gift to Minors Act (UGMA) account and other means of establishing an account in the child's name. (Link to College Planning/UGMA section) The higher your tax bracket, the more effective this technique may be.
  Note: There are certain limitations and restrictions on ownership and taxation when investing in a child's name. Consult your tax adviser.
  
  

What mutual fund income is taxable on my state income tax?

The rules vary widely from state to state, so it's best to consult a local tax adviser. However, here are a few general rules to keep in mind:

• Most states do not tax income from municipal bonds issued within that state. To the extent your distributions are derived from state or local tax-exempt bonds, they may not be taxable.
  
  
• Distributions derived from U.S. government securities may or may not be taxable, depending upon which state you live in and the exact type of federal securities your fund invests in.
  
  

What kinds of information will my fund company provide?

All fund companies will provide you a tax statement of your dividend and capital gain distributions each year. For a taxable account, you will receive IRS Form 1099 DIV. Proceeds from a sale are reported to you and the IRS on Form 1099B. And if you have distributions from a tax-deferred account such as an IRA, you will receive Form 1099R.

Many fund companies also provide year-end statements which are helpful in calculating your tax obligations; however, it is still suggested that you retain all confirmations and records. A growing number of companies will also provide you a statement of average cost basis (single-category method), either automatically or upon request.

Other information that may be available includes:

1. Data about distributions based on income from U.S. government securities (for state taxes)
   
2. Details about foreign taxes paid on foreign securities. If you have substantial investments in international or global funds, you may want to file for a tax credit on these foreign taxes.
   

How can I obtain mutual fund-related tax information from the IRS?

Call toll-free 1-800-829-3676 to receive IRS Publication 564, Mutual Fund Distributions; IRS Publication 550, Investment Income and Expenses; and IRS Publication 514, Foreign Tax Credit for Individuals or link directly to their site: IRS Website

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