Common Tax Questions
What can I
do to control the tax obligation on my mutual fund assets?
- The most obvious way to minimize the current taxes on your mutual fund earnings is to
invest through a tax-deferred account such as a Traditional 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 generally owe ordinary income taxes on the withdrawal. 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. For children 18 and younger (and dependent full-time students under 24 years of age), the first $900 of investment income earned is not taxable; the next $900 is taxable at the child's marginal tax rate (usually 10%). Once the child's investment income exceeds $1,800 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 Gifts or Transfers to Minors Act (UGMA/UTMA) account and other means of establishing an account in the child's name. 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 advisor.
For taxable mutual fund investments, 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 create 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.
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 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
1099-B. And if you have distributions from a tax-deferred account such as
an IRA, you will receive Form 1099-R.
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:
- Data about distributions based on income from U.S. government securities
(for state taxes)
- 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?
Visit the IRS Website, at www.irs.gov,
or call toll-free 1-800-TAX-FORM (1-800-829-3676) for IRS publications.
Tax laws regarding securities and investment income
can be complex. This site provides a basic understanding of the issues. For
guidance tailored to your personal situation, consult your tax professional.
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