Many investors, including some novices, have a good understanding of what mutual funds are and how they work. But even sophisticated investors may be baffled by the tax implications. Surprisingly, you might owe tax in a year in which you did virtually nothing except watch your account grow.
Let’s start with the obvious: If you sell mutual fund shares, you’ll realize a capital gain or loss, depending on the difference between the amount received and your adjusted basis. Previously, it was often difficult to calculate basis for this purpose, especially if you had acquired shares of the same fund at various times. But now mutual fund companies must provide this information for shares acquired after 2011.
The basic rules for capital gains and losses apply, so a long-term gain is generally taxed at a maximum 15 percent rate or 20 percent for certain upper-income investors (plus a 3.8 percent Medicare surtax may be imposed). Losses can offset capital gains plus up to $3,000 of ordinary income.
What’s not as obvious is that annual distributions of capital gains and dividends are taxable, as reported on Form 1099-DIV, even if those amounts are automatically reinvested. As with long-term capital gains, qualified dividends may be taxed at a maximum 15 percent or 20 percent rate (plus a potential 3.8 percent surtax). Be careful not to pay tax on these amounts again when you sell the shares.
Another trap: Mutual funds often pay out dividends near the end of the year (i.e., the “ex-dividend date”). Thus, you may owe tax if you invest in a particular fund just before this date. Alternatively, you might wait until the ex-dividend date has passed to acquire shares in that fund.
These are just some important tax aspects to mutual fund investing. Make sure you understand all the ramifications.
David Compton is a Certified Public Accountant with offices in Meridian and Birmingham, Ala.