Steering a tax course with mutual funds
Boston — If the debate over tax reform accomplishes nothing else, it may force people to think a bit more about their own taxes: how much they keep, how much they pay to Uncle Sam, and how they can keep more. Investors in mutual funds have a particular problem, since they have no control over whether the fund managers keep stocks in the portfolio long enough to qualify for long-term capital-gains treatment or sell those stocks quickly, making their shareholders take any gains as short term, taxable as ordinary income.
But there are some things mutual fund investors can do to make it all less taxing.
Often, investors forget about tax consequences when they are switching in and out of funds, trying to anticipate or catch up with business and economic trends. Although many mutual fund ``families'' permit several free switches a year and heavily promote the service, they don't often mention taxes. If you move out of a fund in less than six months, even if you're moving from one of several funds in a ``sector'' group to another in that group, any gains will be taxed as ordinary income, at the same rate as your salary, for instance.
If you can hold on to your mutual fund shares at least six months, you are entitled to a deduction equal to 60 percent of the capital gain. Put another way, that leaves only 40 percent of the gain that is taxable, which translates into a maximum tax of 20 percent of the gain for someone on the 50 percent bracket. Of course, the maximum capital gains tax is lower for those in lower income brackets, too.
Then there is the question of distributions. To avoid taxation on the fund itself, most mutual funds distribute almost all their net investment income and net realized capital gains to shareholders. Usually, shareholders will ask for automatic reinvestment of these dividends, because it makes the investment compound and grow faster.
But that does not mean investors won't hear about those distributions. They must be reported every year as taxable income.
If you've had any distributions this year, you'll see them on the Form 1099 you receive from the fund in January. The distributions should be separately identified as to type, so they can be properly listed on your income tax return.
You'll also be told about any dividends. These represent the fund's net investment income, minus any fund expenses, and are taxed as ordinary income. If the dividends are from a stock or bond fund, they qualify for the $100 exclusion available to single taxpayers and the $200 exclusion used by married couples. Dividends for money market mutual funds, though, don't qualify for the exclusion.
People in mutual funds that invest in municipal bonds don't get notices about distributions or dividends; they get the income from those securities. This income is free of federal taxes, and perhaps free of state taxes, especially if the bonds were issued by that state, some city or town in the state, or some other government agency.
Another way to protect your mutual fund's good performance is to pay attention to how you use the fund. If you have some funds that are providing a high yield and others with a lower yield, use the higher-yielding fund for a tax-free or tax-deferred account like an individual retirement account, a Keogh, or a college savings account for children or grandchildren.
Pay attention to distribution dates, too. When you buy mutual fund shares, whether from a broker or over the phone with a no-load fund, ask when the last distribution was made, or if it has been a while, when the next one is due. Then buy your shares after that distribution occurs. If you buy a fund with a net asset value of $25 and it makes a distribution of $2 a share, its net asset value will drop to $23 and you'll have to pay taxes on that $2.
Also, if you wait to invest until after the distribution, you will get more shares for the same about of money. Say you wanted to put up $10,000 for those shares. If it was a no-load fund and you came in at $25, you'd get 400 shares, plus having to worry about that instant tax burden on the distribution. But if you waited, your $10,000 would get you about 435 shares at $23 each, and you wouldn't have to worry about taxes so soon.