How to Avoid Double Taxation on Mutual Funds
Simplicity is one of the biggest advantages of mutual funds, except for taxes. But you can fully enjoy the benefits and reduce the anxiety about complexities if you know some tax rules and tactical tricks for investing in mutual funds.
How Mutual Funds Are Taxed
Mutual funds are not like other investment securities such as stocks, as they are considered individual portfolios. They are called pooled investments and contain dozens or hundreds of other securities.
The taxable activity that occurs as part of managing a mutual fund transfers the tax responsibility to you as an investor in the mutual fund. You will be liable to pay taxes at two levels if the stocks you hold in the mutual fund pay dividends, and then the fund manager sells the stocks for more than what they paid for them:
- Capital gains tax, which is usually applied at your income tax rate
- Capital gains tax, which will be taxed at the capital gains tax rate
It is possible to receive a long-term capital gains distribution (provided the mutual fund held the stocks for more than a year) even if you have only held the mutual fund for a few months and haven’t sold any shares.
Note: The taxes distributed to you relate to activities within the mutual fund, not due to your own investment activities.
How Investors Incorrectly Pay Double Taxes on Mutual Funds
Suppose five years have passed, and you sold your mutual fund. Your original investment was worth $10,000 in fund shares and it paid $400 annually in dividends for five years.
You are a wise long-term investor, so you decided to reinvest all dividends into more shares of your mutual fund. You did well in choosing your mutual fund, and the value of its shares, including reinvested dividends, gives you a final value of $15,000 at sale.
You bought the fund for $10,000 and sold it for $15,000, so you’ll pay tax on $5,000 as capital gains, right? Yes, if you are like millions of investors who make the same mistake. You will pay tax on the $5,000 as “gains,” but that will be too much.
Remember, your original investment was worth $10,000, but you also invested (or rather reinvested) $2,000 as dividends. So your basis is $12,000, and the taxable profit is $3,000, not $5,000.
How to Avoid Paying Twice
This example is simplified and does not take into account compounding, but the lesson is the same: most investors believe that the amount they invested in the mutual fund out of their own pockets is the initial amount of the investment or the “basis” for tax reporting. However, the IRS states that all distributions reinvested from dividends and capital gains are also considered “investments.”
You can avoid the same mistake simply by keeping all your mutual fund data and paying attention to all invested amounts. More importantly, pay attention to the “reinvested” amounts.
You can also refer to the IRS Publication 550 tax guide. Better yet, keep your records and give them to your tax professional while you go on with your daily life.
Frequently Asked Questions (FAQs)
What is the difference between long-term and short-term capital gains?
A gain is long-term if you hold an asset like a mutual fund for one year or less. It is long-term if you hold it for more than one year. Short-term gains are taxed as ordinary income according to your tax bracket. Long-term gains are taxed at a rate no higher than 20%, but most people do not pay more than 15%.
Do
Can I offset gains with losses?
Capital losses can offset your gains to some extent. You can claim losses up to $3,000 (or $1,500 if married filing separately) or your net overall loss, whichever is lower.
The information provided on this site is for discussion purposes only and should not be construed as tax or investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
Thank you for your feedback!
Sources:
Budget. “Why do I need to report capital gains from mutual funds if I didn’t sell any shares of those funds?”
Budget. “How are reinvested gains reported on my tax return?”
Budget. “Topic Number 409: Capital Gains and Losses.”
Source: https://www.thebalancemoney.com/how-to-avoid-the-double-taxation-of-mutual-funds-2466698
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