Buying
Before you invest a large amount in a mutual fund, ask about the
realized gains in its portfolio. If they represent a significant
portion of the fund's net asset value (NAV) and the record date of
the next capital gains distribution is near, you may want to delay
your purchase until after the record date. Otherwise, you'll "buy
the dividend," and that can cost you money in taxes.Say you invest $5,000 on December 15 (record date), buying 250
shares for $20 each. If the fund pays a distribution of $1 per share
on December 16, its share price will drop to $19 (not counting
market change). You still have $5,000 in value (250 shares x $19 =
$4,750 in share value, plus 250 shares x $1 = $250 in
distributions), but you owe tax on the $250 distribution you
received—even if you reinvest it in more shares.
To avoid buying a dividend and having to pay current tax on it,
check a fund's distribution schedule before you invest. Keep this in
perspective, though: This rule of thumb primarily applies to large
lump-sum investments. So evaluate both the size of your investment
and the size of the fund's impending distribution before deciding to
hold off buying until after the record date. If the amount you're
investing is fairly small, it's probably not worth waiting. And if
you make regular investments every month, don't let buying the
dividend derail your program. It's better to buy the dividend than
to fail to invest.
Selling
At some point, you'll undoubtedly redeem shares from your taxable
accounts. When you do, you can lower the net capital gains subject
to tax by selling shares from a fund that has lost value at the same
time you sell shares in a fund that has gained value. This will
allow you to offset the realized capital gains in the second fund
with losses in the first. It's very important to keep in mind that
you shouldn't sell securities or fund shares only for tax purposes.A common mistake investors make is to sell or exchange shares of
a fund simply to avoid receiving a distribution. For example, say
you bought 1,000 shares of a fund that cost $10 per share. Two years
later, when the shares are worth $12 each, the fund announces it
will distribute a $1 long-term capital gain for each share. You can
stay in the fund and pay tax on $1,000 in capital gains
distributions or redeem your fund shares and pay tax on a long-term
capital gain of $2,000.
As the table below shows, it may make sense to hold the
investment and pay tax on the fund's distribution instead of selling
your shares and paying tax on your capital gain.
Fund Distributions
|
Should You Hold or Sell?
|
| If an investor … |
The taxable
distribution or long-term capital gain is … |
At the
maximum 15% capital gains rate, the tax owed is … |
| Holds shares |
$1,000 |
$150 |
| Sells shares |
$2,000 |
$300 |
Don't pay taxes twice: Be sure to include income and capital gain
distributions you've reinvested in a fund when determining the cost
basis of the shares you're selling. Calculating your cost basis is
one of the more complex aspects of tax reporting for your mutual
fund investments—especially when you've bought shares of your fund
at different times. |
