Taxes and Mutual Funds- In Plain English

A few clients called recently and asked why they had to pay tax on the mutual funds they own even if they didn’t sell them.  I figured you might be interested in the explanation too.  Taxes and mutual funds seems tricky. But in reality, the way mutual funds are taxed is actually very straight forward. All you have to do is break it down.

You see, there are three different events that can trigger a tax when it comes to owning mutual funds:

1. When the fund pays a dividend (reinvested or not).
2. When the fund pays a capital gain (reinvested or not).
3. When you sell your fund.

Let’s discuss each one of these and you’ll see how they work right away. I think you’re going to be amazed at how quickly you master this.

1. The Fund Pays a Dividend

Not every mutual fund pays a dividend. It depends on the securities held within your fund. If your fund holds bonds that pay interest or stocks that pay dividends like preferred shares, the fund will collect dividends. In that case, the fund will very likely pay out dividends to the shareholders. When they do, it creates a tax liability for the people who own shares.

Let’s say you bought 100 shares of ABC Mutual Fund and you paid $10 per share. Assume the fund paid out a $.50 per share dividend a few months after you bought the shares. That means you will be eligible to receive a grand total of $50. If you tell ABC to send you a check, they will do so. If you tell ABC to reinvest the $50 and buy more shares instead, they’ll do that. Regardless of what you decide to do with the $50, you will have to pay taxes on the $50.

But Neal, if I didn’t receive the $50 and reinvested the money instead, why should I pay tax on it?

Because you actually did receive the $50. You got the money and then you bought more shares with the cash. It just happened automatically. The way Uncle Sam looks at it, if you could have received the money, it’s a taxable event. End of story.

But Neal, where am I going to find the money to pay the tax?

That’s your problem. Uncle Sam doesn’t care. Just send them their money – or else. You do get to increase your cost basis of the mutual fund by $50 if you reinvest the dividend. That way when you sell your shares later on, you will actually pay less tax. Let’s move on.

When the Fund Pays Out Capital Gains

During the year, your fund buys and sells securities. Some of those transactions result in happy gains and others result in unhappy losses. Near the end of the year, the managers of the fund add up these gains and losses. If there is a gain, they treat it like a dividend. You can either take the money or reinvest it. (If there is a loss, the fund carries it forward to offset future gains in years to come.)

From a tax standpoint, it doesn’t matter. Take the cash. Reinvest the money. Whatever you want is fine. You are still going to pay tax on the capital gain just like with dividends. There a few ways to minimize the capital gains tax, but you are still going to have to cough up the dough. The only difference is that capital gains are currently taxed at different rates than dividends.

Also, some of the gains of the fund will be short-term gains and others will be long-term gains – depending on the length of the time the fund held the security before they sold it. Short and long-term gains are also taxed a little differently but don’t worry about this right now. That’s why you have an accountant.

When you get your end-of-year statement, the fund will spell out how much of that capital gain was short-term and how much was long-term. They are required to do this so you can file your tax return accurately.

Again, if you reinvest the shares the value of that reinvestment increases your cost basis. It will ultimately reduce the tax you pay when you sell your shares. You’ll see how that works now as we look at selling your shares which is the last event that triggers tax when you own mutual funds.

When You Sell Your Shares

Let’s go back to ABC mutual fund. You paid $10 per share when you first purchased the security if you recall. But you also increased your cost basis by $.50 per share when you reinvested your dividends. Let’s say you now sell your shares for $10.25.

Do you have a gain or a loss on this transaction? If you said “a loss” congratulations! You are a mutual fund tax master! You paid $10 per share. That’s true. But because you reinvested the dividends, your actual basis is $10.50. If you sold the shares later on for $10.25 you lost $.25 per share.

If you had reinvested more dividends or capital gains, your cost basis would have climbed even higher and your tax loss would have been greater. Of course losing money is nothing to celebrate but it is kind of cool that you understand how it works. Right?

What do you do if you don’t want to mess with all this?

First of all, this stuff might still seem a bit foggy but your tax preparer handles this for you pretty easily. I don’t think you should make your investment decision based on this issue alone. But if you still don’t want to deal with taxes on mutual funds, you have alternatives. . Look for ETFs (and mutual funds for that matter) with very low turn-over and that hold securities that pay no dividends. You can get all this information very simply by reading the mutual fund prospectus.

Again, let me emphasize that I don’t think this route is a good one. Why restrict your investment selection and possibly eliminate some very good options just because they pay dividends and capital gains? Makes no sense to me.

Does the subject of mutual fund taxation perplex you? Do you stay clear of funds that expose you to this problem?