Investing For Beginners – Free Investment Articles and Tutorials

As a well-diversified investor, you most likely have a portion, if not your entire portfolio invested in mutual funds. If so, there are some common sense basics to keep in mind when its time to file your yearly taxes. First, you must pay taxes on mutual fund distributions of dividends and capital gains. Second, you must pay taxes on sales of mutual fund shares. (Unless it is in a IRA or other tax sheltered account) Third, you’re investment company will mail year-end forms related to your investments needed to complete your taxes.

And finally, and this can’t be stressed enough, always consult a tax professional if you have any questions regarding the taxation of your investments. The last thing you want is an audit notice in the mail from the IRS. So why bother reading further? There are some basic principles expressed here that will help you better plan during the year, and have a better understanding regarding the taxing of mutual funds.

When an individual invests in a mutual fund, there are three potential sources of income, dividends, capital gains, and capital gains/losses on sale of shares. Dividend income is derived from stock dividends and interest from bonds, net of expenses. These may be paid monthly, quarterly, or yearly, depending on the fund. Another potential source of income is capital gains on sales of shares. When an investor purchases a mutual fund, he/she essentially purchases a portfolio of securities that are professionally managed.

When the fund manager sells shares in the portfolio of the mutual fund (for a gain/loss), the gain or loss must be distributed to all owners of the fund in the form of a capital gains distribution. This is done typically in December, and because the fund is actually paying itself, the share price drops by approximately the same amount of the capital gains distribution. The final potential source of income is capital gains on sale of shares. This is when an investor sells shares of a mutual fund for a profit (or a loss). This gain/loss on sale of shares is a taxable event and can taxed as ordinary income and subject to an investors applicable tax rate if the shares are held for less than one year. If the shares were held for more than one year, the sale would be taxed at the maximum capital gains tax rate of 20%.

A slight digression on capital gains distributions. Mutual fund companies typically pay out capital gains distributions in December. As mentioned earlier, if the capital gains distribution two dollars per share, you can expect the mutual fund’s price to fall two dollars the day after the distribution is made. (Ex dividend date). If an investor purchased the fund in early December, he/she will receive the capital gains distribution and be taxed on the distribution. An investor will also notice an almost immediate drop in share price equivalent to the amount of the capital gains distribution, which is normal. The caveat here is that an investor hasn’t realized any discernible appreciation in share price, but does have an immediate tax burden! The key here is to put off year end investing until AFTER the cap gains distribution has been made. This well known, yet not highly publicized pitfall has trapped many investors into a tax burden they weren’t prepared for!

Starting sometime in late January or early February, investors begin to receive forms from your investment firm. The most common forms are the 1099-B, the 1099-Div, 1099-R and 5498. The 1099-Div is exactly what is says. It is a disclosure of how much you received in dividends and capital gains distributions (except for IRA’s and other tax-free retirement plans) and is taxed as ordinary income (your applicable tax rate) The 1099-B simply reports sales of mutual fund shares. What an investor should keep in mind is how long the mutual fund shares were owned. If they were owned less than one year, the gain/loss will be taxed as ordinary income and thus taxed at the ordinary income tax rate (between 15% and 39.6%). If you held the shares for longer than one year, the gain/loss will be taxed at the maximum allowable cap gains rate. Lastly, the 1099R is sent to you if a redemption was drawn from a retirement account during the year, and finally the 5498 is sent to indicate what contributions were made to a retirement account. The 5498 does not come out until May however, as investors have until April 15th to make contributions to their retirement accounts.

Pretty simple right? Probably the most complex issue regarding taxation of mutual funds is the dreaded ‘cost basis’ the most time consuming aspect of mutual fund tax reporting. If shares of a mutual fund are sold, an investor needs to know how much was paid for them in order to determine a profit or a loss. The IRS currently allows three methods to determine cost basis. “FIFO” (first in, first out), which is when the oldest shares are sold first, and the cost of these shares is used as the cost basis. The main problem here are possible whopping cap gains on sales of shares assuming that there has been considerable appreciation in the fund. The second cost basis method is, “specific shares” where an investor chooses shares that he/she wishes to use as a cost basis. One can select the most expensive shares to lessen the tax burden, but due to the impeccable record keeping necessary, this method is seldom used. The most common and frequently used is “average cost”. The total cost of all shares, divided by the number of shares owned, is the average cost. Again, it is key to keep accurate records and statements determine average cost. Some mutual fund companies provide the average cost, but if not, you’ll need to refer to your own records. One thing to keep in mind is that once you choose a ‘cost basis method’ you cannot change from one year to the next.

Finally, I’d like to pass on a few tips that will hopefully help this year and next.

Avoid year-end investing. This will ensure that you won’t be hit with a capital gains distribution tax on a fund you’ve only owned for a month!

Make certain that income and capital gains are reported accurately on the tax forms. They’re taxed differently, so be cautious not to include them in one sum.

Up to three thousand dollars in capital losses can be used as a deduction, and can be carried forward if more than three thousand dollars.

Keep statements and accurate records. It will help with determining cost basis at tax time.

Finally, make certain the tax id on the account is accurate. Inaccurate tin numbers can lead to 31% withholding if discovered by the IRS!

Hopefully this article has helped explain some of the mystery behind mutual fund taxation. Next week well take an in-depth look at pure income funds, funds that pay a monthly dividend income, how they’re taxed, and how your “tax free” or “tax exempt” funds may not actually bee 100% tax free!

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1. The Taxman Cometh Part II
2. Tax Tips for Mutual Fund
3. Dividends, mutual funds distribution
4. Taxation of investment funds
5. Dividend Taxation
6. Fund of funds
7. Why invest through a mutual fund?
8. Taxation
9. Dividends: The Basics
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