There are two main tax considerations when you invest in a mutual fund: How the investments within the fund are taxed and the taxes incurred when you exit the fund (sell your shares).
Taxes on the Investments within a Mutual Fund
When you sell an investment, any profits count as capital gains and are subject to short- or long-term capital gains tax, depending on how long you held the investment. In the same vein, selling an investment at a loss counts as a capital loss, which can offset any potential gains from a tax standpoint.
This same principle applies to investments within a mutual fund.
If your fund manager chooses to sell assets for a profit, the fund generates capital gains that could be taxable. Similarly, any dividends paid by investments within the fund may be subject to taxation, along with interest from certain types of bonds.
Generally speaking, these taxes are passed on to the mutual fund’s shareholders.
Capital gains taxes are assessed based on how long the fund held the investment, independent of how long you’ve been invested in the mutual fund.
Fund managers may sell other investments at a loss in an attempt to offset capital gains and provide a tax benefit for shareholders. Check the mutual fund’s prospectus for mentions of tax-loss selling.
One thing to watch out for: In down markets, investors might pull money out of mutual funds. Depending on the volume of the outflows, and the fund structure, the fund manager may need to sell some of the fund’s holdings to generate the cash to redeem those shares. This can lead to significant capital gains, and therefore, capital gains taxes, even if the overall value of the mutual fund has fallen along with the market.
Taxes When You Sell Shares of a Mutual Fund
If you sell your mutual fund shares at a profit, the difference between what you paid for the shares and the sale price counts as a capital gain.
If you held the shares for less than a year, any gains would be classified as short term, meaning they’re taxed at the same rate as ordinary income. Long-term capital gains are taxed at a different, often lower, rate.
Because the IRS taxes you on the difference in price between when you buy and sell shares, it’s important to keep track of when you buy shares of a mutual fund and at what price. This provides a cost basis that can significantly impact the amount of your capital gains. Let’s review an example. (For the purpose of this example, we’ll assume there are no other capital gains or losses to consider.)
Say you have 30 shares of Mutual Fund A. You bought 10 shares three years ago for $100 per share. Then, you bought 10 more shares a year later for $120 a share. Six months ago, you bought an additional 10 shares for $140.
Fast forward to today: Shares of Mutual Fund A are valued at $150, and you decide to sell 10 shares. If you sell the first 10 shares you bought, you would make $50 per share ($150 sale price minus the $100 purchase price). Taken all together, you’d owe long-term capital gains tax on $500.
If, on the other hand, you sold 10 shares you bought just six months ago, you’d make $10 per share, or $100. However, since you held that investment for less than a year, that $100 would be subject to ordinary income tax.
You could also sell the 10 shares you purchased for $120, or some combination of the three. Which option makes the most sense likely depends on a variety of factors. That’s where tax planning can help.
Mutual Funds and Tax Planning
Whether or not you decide to invest in mutual funds likely won’t depend on taxes alone. But tax rates can be an important consideration.
If you incur any capital gains, either via investments within the fund or from selling shares of the fund itself, you should get a Form 1099-DIV documenting the gains.
A financial advisor can help you evaluate the tax component of different mutual funds. Advisors can also help you get strategic about cost basis or employ additional tax strategies, such as tax-loss harvesting or carrying losses forward.
While Bogart Wealth does not offer tax preparation services, we can work with your tax accountant to figure out the best approach for you. Contact a Bogart Wealth Advisor to learn more about tax planning.
