How to Understand Mutual Fund Taxes
A mutual fund pools the funds of many investors and then uses those funds to purchase investments in various securities. The investor receives shares in this pool that correspond to the amount of money invested in the pool. Mutual funds are pass-through entities, which means they don't pay taxes. Instead, all taxable income is passed on to shareholders via distributions. Additionally, when investors sells their mutual fund shares, they may also be taxed on any profits from the investment.
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Capital Gains Taxes
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Taxes are due whenever selling mutual fund shares results in a profit. These taxes are called capital gains taxes. There are two kinds of capital gains: short-term and long-term.
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Know the difference between short-term capital gains and long-term capital gains. Short-term capital gains are due on mutual fund shares held for less than one year from the date of purchase. Long-term capital gains are due on mutual fund shares held for more than one year from the date of purchase.
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Figure out the difference between long-term and short-term capital gains tax rates. Long-term capital gains are taxed at a flat rate of 15% for most taxpayers. Certain lower-income taxpayers may qualify for a rate of 5%. Short-term capital gains, however, are taxed as ordinary income.
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Understand that capital losses can be used to offset capital gains. However, only short-term capital losses can be used to offset short-term capital gains. In addition, up to $3,000 of losses above and beyond any gains may be deducted from the investor's ordinary income.
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Learn about the carry-forward provision. If an investor has more losses in a given year than gains, those losses may be deducted up to $3,000 in any tax year. However, any additional amount of losses may be carried forward into future tax years. For example, an investor who lost $10,000 in a tax year may only deduct up to $3,000 for that tax year. The remaining $7,000 may be used to offset any investment gains made in future years. If the investor had $8,000 worth of capital gains the following year, the investor could use the losses that were carried forward to reduce the amount of taxable gain to just $1,000 for that tax year.
Taxes on Mutual Fund Distributions
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Understand that the investment activities of mutual funds create taxable events. However, mutual funds themselves do not pay taxes. Rather, mutual funds pass any tax liability on to their shareholders via distributions.
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Realize that mutual fund distributions are made so the investor may pay the appropriate tax. There are different types of distributions depending upon what taxable events occurred. For example, taxes must be paid on dividends paid by stocks and bonds that the mutual fund owned during the tax year. Likewise, when the mutual fund sells an investment at a profit, that creates a capital gain.
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Learn the various types of distributions. There are two main categories: capital gains distributions and dividends and interest distributions. For capital gains, there are two kinds, short-term, and long-term. For dividends and interest, there are also two kinds, qualified and non-qualified.
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Determine how to report each distribution. Investors will receive a 1099 form each year from their mutual fund investments detailing any distributions made and their type. These amounts are reported on the Internal Revenue Service's Schedule D.
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