Consider Taxes

Sometimes a decision as basic as when to buy or sell mutual fund shares can impact how much you pay in taxes. Understanding mutual fund tax issues can help you keep an eye on taxes -- while still working toward your long-term financial goals. 

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

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 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. 

There are also two basic categories of capital gains:  

• Short-term in which the assets are held one year or less. Short-term gains are taxed at your ordinary income tax rate.

• Long term in which assets are held longer than 12 months. 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.

NOTES:

• 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.

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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