When you begin investing as part of a general wealth management or retirement plan, it’s smart to recognize that your earnings calculation must include capital gain taxes on mutual funds. Not knowing when and how these sums are taxed — and at what rates — means you also may not be clear on how much value your shares have gained, or the relative costs involved in maintaining that investment over another form.
This guide will cover everything you need to know to understand your portfolio’s value and be sure you’re paying your taxes appropriately.
What Is a Mutual Fund?
A mutual fund is an investment product that combines money from various investors and uses those sums to purchase assets, thereby bringing in benefits to the shareholders involved. Dividends or interest can be paid when those assets grow in value, and how these payments are structured depends on the type. Common options include:
The general principle is that a yearly fee covers the costs of creating and managing a mutual fund. In return, you benefit from the wisdom and experience of the mutual fund manager, who chooses when to buy and sell assets that are part of the fund. A few facts:
- These investments can also have fees associated with multiple steps in the management process.
- No-load mutual funds let you make your own purchases, for example, but still have administrative charges.
- Load mutual meanwhile offer the assistance of a financial advisor who can help you choose when and how to purchase in exchange for a commission.
There are various investment tools, too — including variations like commingled and specific types like index funds — and each will focus on different kinds of assets as well as risk tolerances. Once you’ve learned a bit about the available options, you’ll want to factor in the way they are taxed before deciding which is right for you.
How Are Mutual Funds Taxed?
Taxes on these kinds of investments happen during at least two timeframes: when you earn dividends and interest, and when you sell your shares in the mutual fund down the road.
Near-Term Taxes While You Hold Mutual Funds
“Capital gains” refers to when a profit is seen on the sale of assets in your mutual fund and counts as taxable income. Keep these facts in mind:
- If your fund manager chooses to sell assets and makes a profit, the fund will generate capital gains that could be taxable.
- Such taxes may seem high, but there is the possibility of capital losses in other parts of your portfolio.
- These losses would cancel out parts of your capital gains, which could result in less tax liability and related tax.
- You’ll be informed about any dividends that count as taxable for the year in which they are paid out.
- This is usually true even if you reinvest such income and purchase more mutual fund shares, so be sure to pay related taxes correctly.
Mutual funds sometimes invest in bonds, which is important to note because that can mean interest paid to you. Those sums could qualify as taxable, depending on the bond. Keep in mind that some municipal bonds and United States Department of Treasury bond funds may not.
Taxes When You Sell Shares of Mutual Funds
Any positive difference between the value of your shares when you purchased them and that when you sold them is considered taxable. Buying shares over time can lead to confusion, though:
- Tax rates differ on short- and long-term capital gains.
- The rate changes after you’ve held a mutual fund or asset for more than 12 months, for example.
- Work with your wealth manager or investment advisor to ensure you understand the benefits and drawbacks of selling shares so as not to end up with surprises during tax season.
You’ll also want to work with an income tax accountant to be certain your tax return is accurate in terms of capital gains rates.
3 Mutual Fund Tax FAQs
The bottom line is it’s important to understand everything you can about investing — including capital gain distribution, how investments impact your short-term and long-term gains and losses (especially if you’re investing for a specific reason, like your children’s college savings or a 401 (k) or other retirement account), whether yours is a taxable account — and when you’ll have to pay tax on the sums you accrue. Here are some common questions investors have
1. How will I know if I owe taxes on currently held mutual funds?
The Internal Revenue Service (IRS) requires that you be sent a Form 1099-DIV when your assets generate capital gains, dividends, or interest income relevant to your tax situation. This document is very important to calculating the income you need to disclose to the IRS from your investments in addition to your ordinary income. If you have questions about it, you can talk to your accountant or your wealth manager.
2. How can I avoid capital gain taxes?
There are a few options here:
- First, various tax-free, tax-deferred or tax-advantaged accounts — including company-sponsored 401(k) plans and individual retirement accounts (IRAs) — can include mutual funds. They come with special reduced taxes when you first invest sums or when selling shares to receive a distribution from the account. Consider these options when investing.
- Second, choosing a wealth manager who can help you understand when to buy, sell, and hold your assets can be crucial to avoiding paying too much.
- Lastly, your tax strategy with your accountant contributes to your income falling into lower tax brackets, so even capital gain tax is lowered if you reduce your overall tax liability.
Your best bet is to speak with fund managers or a tax professional before getting too deep into your moves as an investor to be certain you’re taking all the important tax considerations or factors related to type of distribution into account.
3. How can I reduce the time it takes to calculate mutual fund taxes after a sale?
The IRS has two ways — cost basis and average basis — to calculate what you owe for tax purposes, and your wealth manager can help you determine which makes the most sense given your mutual fund purchasing patterns. In general, the average basis is helpful when you can’t determine the original price you paid for your mutual fund shares. Cost basis is more for people who have very good records available for calculating each mutual fund’s purchase and sale price.
Understanding mutual fund taxes involves some high-level discussion of how taxes are assessed and the nitty-gritty of your own tax situation. Working with an expert can help you clear up any of those issues and ensure you’re doing all you can to protect your investments and finances.
We’re Here for You
If you have questions about mutual funds, ordinary income tax, tax rate, capital gain distributions, or other investment-related information, contact Bogart Wealth today. Our team of professional wealth managers are here to answer all your questions and help with various other financial issues, from banking and investing to mortgages, insurance, and more.