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Mutual Fund Taxation

Calculating the tax due from the sale of mutual fund shares does nothing to heighten the enjoyment that comes with spring and tax-time.  As a matter of fact, as popular as they have become as an investment vehicle, mutual funds can be downright scary at tax time.

The owners of mutual funds have little control over the tax implications that come with owning a fund.  Funds are managed by managers who have been given discretionary authority by the shareholders of the fund to buy and sell the securities within the fund.  Their actions, completely outside the shareholder’s control, create the tax consequences.

Mutual funds generate liabilities three ways for investors.  First, if the fund collects interest (non tax-exempt) or dividends they must pass through the realized interest and dividends to the shareholders at least once a year.  These are taxed at ordinary income tax rates.

Second, if the fund buys and sells securities during the year, the fund creates short and long term capital gains or losses.  Again, these must be passed through yearly to shareholders.

In these two cases, even if the fund shareholder elects to use the distributions to buy additional shares, the distributions are still taxable.

Finally, if the shareholder sells shares, and a gain or loss is realized by selling for more or less than the cost basis, the shareholder may have either short-term, if the shares sold were held for less than 12 months, or long term gains or losses.

Now for the scary part…it is possible to purchase a mutual fund one-day, and get hit for a big tax bill the next, if the fund has realized significant tax gains during the year and not done anything to offset the gains with losses. 

For example, suppose an investor buys a fund that invests in small companies.  If the fund manager holds these stocks for several years, allowing the companies to grow, at some point he will sell the stocks, since the companies have outgrown the investment objectives of a small company fund.  When this occurs, whoever owns the fund at the time of year the fund makes its taxable distribution gets stuck with the reported tax gain. 

Therefore, an investor could buy one day and shortly thereafter get hit with a large taxable gain.  To add insult to injury, even if the value of the investment falls due to lower share prices, the gain from the distribution is still taxable.

If you sold shares during the year, you will need to determine your gain or loss by subtracting your cost basis from the sales proceeds.  The IRS allows three methods for determining the cost basis—First In, First Out (FIFO), Average Cost, and Specific Identification.  The Average Cost method, which is the most commonly used, requires you to determine the average cost per share—total dollars invested divided by the total number of shares held.

The Average Cost approach has two variations: double-category and single-category.  With the former method, you divide your shares into two groups: those held longer than one year (long-term shares) and those held one year or less (short-term shares).  Then, figure the average cost per share for each group.  With the single-category method, you figure the average cost per share for all shares held in the account, and any shares that are sold are considered to be those held longest in the account.

Regardless of which method you choose, you need to keep copies of your year-end statements or confirmations to accurately calculate your cost basis.

Securities offered through Sigma Financial Corporation. A registered broker/dealer. Member FINRA & SIPC.

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Last modified: 11/04/07