Beware of Mutual Funds' End-of-the-Year Tax Trap
CBN.com November and December are the most dangerous months of the year for investors with money in taxable (i.e., non-retirement) accounts.
In the process of investing, mutual funds incur capital gains and losses, and receive dividend and interest income on their investments. From a tax point of view, all of this is done on behalf of their shareholders. It's as if you owned all the investments outright, and the gains and losses that result are all your personal gains and losses.
There are three ways this happens:
Funds invest in stocks that pay dividends. They collect the dividends and pay them out to you periodically.
Funds invest in bonds or other debt securities that pay interest. They collect the interest and pay it out periodically.
Funds sell one of their investments for more than they paid for it, thereby making a capital gain. They keep track of these gains (and offset them against any capital losses), and pay them out to you periodically, usually annually.
All of these payments to you are called "distributions." The fund decides whether to make these periodic distribution payments monthly, quarterly, semiannually, or annually — but most of the time they occur near the end of the calendar year. The amount you receive depends on how many shares you own.
A fund goes through a two-step process in making distributions. First, it "declares" the amount of the distribution it intends to make, and sets aside the appropriate amount of cash that will be needed to write you a check.
This has the effect of suddenly lowering net asset value of the fund — one day the money was being counted as part of the fund, and the next day, the day of the declaration, it wasn't. The date this happens is called the "ex-dividend" date, and is the significant date as far as your taxes are concerned.
The second step of the distribution process is when the fund actually mails your check. This is called the "payment date" and is important only because that's when you finally receive the cash that's been promised. The payment date has no significance when computing your taxable income.
Let's look at two common misconceptions that investors have about fund taxation.
Misconception #1: "As long as I don't sell any of my mutual fund shares, I won't have any capital gains taxes to pay." The mutual fund, within its portfolio, is continually buying and selling securities. Each time it sells one, it has another capital gain or loss. Since the tax law considers all of this as being done on your behalf, you participate in your fair share of that gain or loss at the time the fund declares a capital gain distribution.
When you eventually do redeem (sell) your fund shares, any capital gain or loss from the original purchase must be reported on Schedule D of your form 1040 tax return just like any other investment. One easy way to put off paying this kind of capital gains tax is simply to avoid selling mutual funds for gain just before the end of the year. If you sell in December, then taxes will have to be paid by April 15, just three and a half months later.
Instead, you might wait to sell until the first week of January. The tax on such gains would then not be owed until April 2012. By the same token, a good time to sell a fund if you have a loss is in December, as the loss will be deductible on the tax return filed only a few months later.
However, there is a complicating factor. Unless Congress acts in the next few weeks, several tax provisions will change on Jan. 1, 2011. Long-term capital gains, paid on investments held longer than one year before being sold, are currently taxed at 15% for most taxpayers. That rate is scheduled to rise to 20% in January.
In addition, unless Congress acts (it may — no one knows), dividends will no longer be taxed as capital gains as of Jan. 1 but as "ordinary income," meaning the tax rate on dividends would rise for many taxpayers — perhaps sharply (depending on one's tax bracket).
For these reasons, it may be unwise to push mutual-fund transactions with tax implications off into 2011. You may face a bigger tax bite if you do so.
Misconception #2: "It's a good idea to invest in a mutual fund just before one of its periodic distributions." Actually, it's a bad idea because it will create an immediate tax liability for you. If an investor buys a fund today and the fund declares a distribution tomorrow, the investor owes tax on the amount of the distribution. There is no actual profit in owning a fund on the day it goes ex-dividend because the amount the shareholders are to receive is deducted from the value of the fund that same day.
Most funds make distributions at roughly the same time each year (December is the busiest month of all), and can usually tell you ahead of time when they will happen. This presents an opportunity for savings.
Before making a major purchase of shares in any mutual fund, call the fund and ask (1) if a distribution will be made soon, and (2) do they have an estimate of the amount. Many funds also post this information on their website. If a distribution is scheduled soon, you have the option of waiting to purchase your shares the day after the distribution to avoid its tax impact.
You can also use this information to advance the sale of any holdings you expect to sell in January for rebalancing reasons. By moving now to sell those positions that are worth less than the purchase, you may be able to avoid a big distribution and also book a loss that will offset other gains on next year's tax return. But keep in mind that if you earn a profit (i.e., you sell your shares for more than you paid for them), you'll have to pay capital gains tax on your profit next April.
One cautionary note: A preoccupation with taxes can end up being counterproductive. Trying to save on taxes can sometimes cause an investor to miss good returns by buying late or selling early. So don't let tax considerations become the overriding factor in your decision to buy or sell a particular fund.
Sound Mind Investing exists to help individuals understand and apply biblically-based principles for making spending and investing decisions in order that their future financial security would be strengthened, and their giving to worldwide missionary efforts for the cause of Christ would accelerate. In other words, we want to help you have more so that you can give more.
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