Mutual Funds and Taxable Distributions

Unless your mutual fund investment is held in a tax-deferred vehicle like a 401(k) plan or IRA, you are responsible for paying taxes on any dividends and capital gains distributions made by the fund during the year. Reinvesting these distributions in the fund does not relieve you of this tax burden. You must also pay taxes on any capital gains on the sale or exchange of shares in your account.

Taxable distributions from mutual funds come in three forms: dividends, short-term capital gains, and long-term capital gains. Qualified dividends are taxed at a maximum rate of 20%. Short-term capital gains from assets sold within 12 months of their purchase are taxed at your regular income tax rate. Long-term gains are currently taxed up to a maximum of 20%.

Remember that each dollar of capital loss can offset a dollar of capital gain. Should your losses exceed your gains, you can offset up to $3,000 of ordinary income. Losses beyond $3,000 can be carried over and deducted from income in future years. To figure out your taxable gain or loss, you’ll need to determine your adjusted cost basis in the shares, using one of several different methods. If you hold multiple shares of different funds, you should take care to keep good records — especially year-end statements — and remember to factor in sales loads when calculating cost basis.

How to Determine a Gain or Loss

In order to determine whether you have a gain or loss on a sale or exchange, you must first know your “adjusted cost basis.” That’s because you will be taxed on the difference between the cost basis of the fund shares and the amount you received when you sold them.

Under a federal law that took effect on January 1, 2011, financial institutions are now required to report cost basis for certain investments to investors, on Form 1099-B, which typically is made available to investors in January of the following year. The expanded Form 1099-B specifies whether a gain or loss was short term or long term. The new cost-basis reporting requirements took effect for certain securities in 2011, and apply to mutual fund shares purchased on or after January 1, 2012.

Previously, when an investor sold a position in a security or a fund, the investor’s financial firm was required to report only the gross sale proceeds to the investor and to the Internal Revenue Service (IRS). It was typically up to the investor to track the cost basis and to calculate the capital gain or loss, and the resulting tax liability, for income tax purposes. The IRS always gave you the choice of accounting methods to determine cost basis.

Ways to Determine Cost Basis

  1. FIFO (first in, first out) — Shares bought first will be sold first.
  2. Specific Identification Method — You specify shares to be sold to provide yourself with the best possible tax benefit.
  3. Single-Category Average Cost — Simply averages the purchase price of all shares bought.

Most financial institutions use average cost as the default tax lot identification method for mutual funds, but you should check before making this assumption. Note that you may still select the cost basis reporting method you prefer.

Some Helpful Hints

There’s no substitute for keeping careful records of all mutual fund investments. Especially important are year-end statements, which generally list the past year’s transactions, including dividends and capital gains distributions. If you’re missing records for any year, ask your fund company to supply them. They’ll be indispensable when preparing your tax return in future years when you sell those shares.

The above guidelines can provide you with some sense of direction as you plan to compile your “index” of taxable transactions from the past year. Of course, you may want to consult a tax advisor regarding your particular situation to ensure that you are making the decisions that are best for you. It can never hurt to have someone “edit” the masterpiece you’ve created.

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