Many investors, including some novices, have a good understanding of what mutual funds are and how they work. However, the tax implications of these funds may baffle even sophisticated investors. One such baffling implication is that you might owe tax in a year in which you did virtually nothing except watch your account grow.
What is NOT obvious
What isn’t always apparent about mutual funds 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% or 20% rate (plus a potential 3.8% surtax). Non-qualified dividends will be taxable at your marginal tax bracket as ordinary income. Be careful not to pay tax on these amounts again when you sell the shares.
What IS 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. You should be careful if you purchased the mutual fund before 2011. You must adjust your basis for any purchase of shares before 2011 and any long-term gains, or qualified and non-qualified dividends that were used to reinvest in more shares.
The basic rules for capital gains and losses apply, so a long-term gain is generally taxed at a maximum 15% or 20% rate for certain upper-income investors (plus a 3.8% Medicare surtax may be imposed). Losses can offset capital gains plus up to $3,000 of ordinary income.
What is also NOT obvious
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 late in the year, just before this date. Alternatively, you might wait until the ex-dividend date has passed to acquire shares in that fund. These are some important tax aspects to consider when investing in a mutual fund. Make sure you understand all the ramifications.
Other less obvious considerations
If you buy a mutual fund after a multiyear bear market (i.e. the Great Recession from 2008 to 2009), the mutual fund may have built up a sizable capital loss. This capital loss can offset subsequent capital gains within the mutual fund. Thus there may not be sizable capital gain distribution for shareholders in the next few years that follow the bear market (i.e. 2010 and 2011).
If you are a buy and hold investor (i.e., you purchased a mutual fund in 2012) and simply hold the shares for a number of years in a rising stock market, then the annual year end distributions of capital gains and dividends could lead to significant tax each year.
On the other hand, if you are a buy and hold investor who purchased mutual fund shares during the Great Recession (for instance in early 2009) then based on past bear markets, you may be exposed to more risk than you previously thought. If there was a sizable and prolonged liquidation of shares by other investors of the mutual fund during the bear market, then the mutual could have a permanent reduction of value because of the requirement to liquidate investments at low prices to meet the demands of other investors to have capital returned. As a result it could take years after the end of the Great Recession before the value of your mutual fund exceeds what you paid for it. But the good news is that the mutual fund likely had a sizable capital loss that will offset future capital gains from this mutual fund for several years. So taxpayers who invested in these mutual funds during the Great Recession likely paid less tax going forward.
So if you are a mutual fund investor there are several things you need to be aware of before you purchase your shares.