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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.
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.
Does a mutual fund pay taxes on the income from its
investments?
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.
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How is this income passed along to me as an investor?
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,
the result is a long-term capital gain or loss. Any profit is passed
onto you as a capital gains distribution.
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How do I report to the IRS the distributions I receive from my mutual fund?
It depends on what type of distribution you receive:
- Ordinary income.
Record ordinary dividends on IRS Form 1040, line 9. If the total of
your dividend distributions exceeds $1,500, 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.
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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."
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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.
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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.
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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.
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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
Usually your year-end statements from the mutual fund will show all
transaction activity for the year and give you a good record of this
information.
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How 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 you specify one of
the others.
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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.
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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.
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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 less.
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, 2004, for a long-term
holding period and capital gain.
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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.
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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.
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Are there any other ways 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 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 adviser.
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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.
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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.
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How can I obtain mutual fund-related tax information from the IRS?
Call toll-free 1-800-TAX-FORM (1-800-829-3676) to receive IRS Publications.
You can also link directly to the IRS website
and download many tax publications, forms and schedules.
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