Mutual Fund Tax FAQ
Get Answers to Questions About Mutual Fund Taxation
You have questions about mutual fund taxation and this article has the answers!
But before getting to the questions and answers on mutual fund taxation, keep these basic account types in mind:
With regard to taxation, there are two primary types of investment accounts:
- Taxable accounts: These are accounts that are funded with after-tax dollars and the income, such as dividends and interest, are taxable to the investor in the year it is earned. Also, earnings (gains) are taxed when the investments are sold. Examples of these accounts include individual brokerage accounts, joint brokerage accounts, and most savings accounts at banks.
- Tax-deferred accounts: These are accounts are funded with pre-tax dollars and/or the earnings (growth) of the investments in the account are not taxed as long as the investments remain in the account. Examples include IRAs, 401(k)s and annuities.
And without further ado, I give you answers to the mutual fund tax frequently asked questions (FAQ):
Dividends are payments to shareholders (investors) of stocks, bonds, or mutual funds. These payments represent a company's profit that is divided among the shareholders. Mutual fund investors will choose if they want dividends to be reinvested (to buy more shares of the fund) or to be received as a cash payment or deposited into another account.
It is important to note that mutual fund shareholders can be taxed on a fund’s dividends, even if these distributions are received in cash or reinvested in additional shares of the fund. Mutual fund dividends are generally taxed either as ordinary income (taxed at the individual's income tax rate) or as qualified dividends (taxable up to a 15% maximum rate). Ordinary and qualified dividends are reported to mutual fund investors on the tax Form 1099-DIV. For tax filing purposes, the mutual investor (taxpayer) will report dividends on Form 1040, Schedule B, and Form 1040, lines 9a and 9b.
If you receive a 1099 does it mean you owe taxes? There are more than a dozen different types of 1099 forms but the most common 1099 forms are generated from investing activities, such as dividends, capital gains, and retirement account (IRA, 401k, 403b) distributions. The most common types of 1099's received by investors include 1099-R, 1099-DIV, 1099-INT and 1099-Q.
- 1099-R: This form is required to be sent to you from the custodian of a retirement account, such as an IRA, annuity, pension, profit sharing plan or 401(k) plan, when you've had a distribution of some kind during the tax year. Keep in mind that a distribution does not necessarily mean a cash withdrawal. Put simply, a distribution means that money was moved out of the account. Examples of types of distributions include a partial or full cash withdrawal or an IRA rollover.
- 1099-DIV: This form is sent to an investor from a mutual fund company to show a record of all dividends and capital gains paid to the investor during the taxable year. Some investors can get confused with form 1099-DIV because they may not have received any form of cash payment from any dividends or capital gains during the year. Even if you choose to have dividends reinvested, you have still received the dividend. And even if you have not sold shares of your mutual fund, you can still have mutual fund capital gains.
- 1099-INT: This form is sent from institutions, such as banks, to account holders that received interest payments of at least $10 during the tax year. Interest, not to be confused with dividends, is most common in bank savings accounts, Certificates of Deposit, and money market accounts.
- 1099-Q: This form is sent to investors who received a distribution from a Coverdell Education Savings Account (ESA) or Section 529 Plan. Generally, taxpayers do not need to pay taxes on distributions that are less than or equal to qualified education expenses.
1099 forms are generally sent to both the IRS and to the individual taxpayer from the institution (i.e. mutual fund company or bank) who distributed the dividend, capital gain, interest or cash withdrawal. Therefore it is not always required for the individual to send their copy to the IRS with their tax filing. However, it is necessary to retain the 1099s and other documents that provide supportive evidence of your taxable and non-taxable activity. In other words, investors should be prepared for tax audits, which will require documentation of your tax filings.
Form 5498 is a tax document issued to holders of tax-deferred accounts, such as a traditional IRA, Roth IRA, SEP-IRA, or SIMPLE IRA. The form is sent by the financial institution where you hold your account and a copy is sent to the IRS. Therefore you do not need to send your 5498 to the IRS with your annual 1040 tax filing. You will also receive a 5498 form for each account you hold.
Form 5498 is for informational purposes and includes contributions amounts you made, the fair market value as of the end of the year, and information on taking required minimum distributions. Along with your 1099-R, your 5498 will be mailed (postmarked) by January 31, following the tax year.
Stock mutual funds may invest in dozens or hundreds of stocks. Often the mutual fund manager will buy and sell shares of several of the stocks within the mutual fund during any given year. When the manager sells stocks that have gained in value since the time he or she purchased those stocks, these trades generate capital gains, which are then passed along to the investor (you).
Cost basis is used to determine your gain or loss for tax purposes when you sell your mutual funds (or other investment types). The cost basis is the purchase price of a mutual fund (or other asset) plus reinvested dividends and reinvested capital gains distributions.
Put simply if you sell your mutual fund at a higher price (expressed as Net Asset Value or NAV) than you bought it, you have a gain. If you sell it at a lower price, you have a loss.
But what happens when you bought shares of mutual funds at various times and prices?
When you acquire mutual fund shares at various times and prices, you will need to calculate the average basis.
To calculate average basis (From: IRS.Gov - Mutual Funds (Costs, Distributions, etc.))
- Add up the cost of all the shares you own in the mutual fund.
- Divide that result by the total number of shares you own. This gives you your average per share.
- Multiply the average per share by the number of shares sold.
You may no longer use the double-category method for figuring your average basis.
Net Unrealized Appreciation (NUA) can occur when you withdraw your company stock from your 401(k) and move it into a taxable brokerage account. The NUA is important if you have company stock that has appreciated significantly and you are transferring the stock from a tax-deferred employee-sponsored retirement plan, such as a 401(k). Keep in mind that distributions like this are typically allowed only when you have a triggering event, such as retirement or termination of employment.
Upon the distribution, the NUA is not subject to ordinary income tax. Therefore, it can be smart to do the transfer of company stock into a regular brokerage account, rather than another tax-deferred savings vehicle, such as an Individual Retirement Account (IRA).
This way, any gain on your shares will be taxed (whenever you decide to sell the shares) at long-term capital-gains rates, which can be as low as 15%. However, if you roll your company stock into an IRA, all withdrawals are taxed at ordinary income rates, which can be as high as 35%.
Mutual funds are not the same as other investment securities, such as stocks, because they are single portfolios, called pooled investments, that hold dozens or hundreds of other securities.
Therefore the taxable activity that takes place as part of the mutual fund management passes along tax liability to you, the mutual fund investor. For example, if a stock holding in your mutual fund pays dividends, then the fund manager later sells the stock at a higher value than he or she paid for it, you'll owe tax on two levels: 1) A dividend tax, which generally taxed as income, and 2) A capital gains tax, which will taxed at capital gains rates.
And even if you've only held the mutual fund for a few months and have not sold any shares, it is possible that you could receive a long-term capital gain distribution (assuming the mutual fund held the stock for more than a year). Therefore the taxes distributed to you are due to the activities within the mutual fund, not due to your own investing activities.
When you go to sell your mutual fund, remember if you've already paid taxes on dividends that have been reinvested. For example, if you buy a mutual fund at $10,000 and sell it later at $15,000, you pay a $5,000 capital gains tax, right? Not necessarily! If you had paid taxes on $1,000 of dividends during your holding period, your taxable portion may only be $4,000.
You have probably given a great deal of thought to investment selection and have implemented strategies for asset allocation but you may not have given much thought to asset location or where your mutual funds are best invested.
Taxation is significantly different in tax-deferred accounts than in brokerage accounts. Selling mutual funds in a tax-deferred account, such as an IRA or 401(k), will not generate capital gains taxes. In fact, selling funds generates no taxes at all (although other mutual fund fees may apply). Also, income from dividends is not taxed in IRAs or 401(k)s until withdrawn at a later time, such as retirement.
Remember that investments held in a brokerage account are taxed on capital gains and on interest income (dividends). For example, if you sell a mutual fund at a price (NAV) higher than the price you purchased it, you will have a capital gain for which you will owe a tax. Also, any interest income (dividends) earned on investments in a brokerage account is taxed as ordinary income, just as if are when receiving pay from an employer.
Therefore, when possible and appropriate for your investment objectives, you can minimize taxes by keeping the income-generating investments, such as bond funds and dividend-producing stock funds, in your 401(k) or IRA, and keep your tax-efficient funds, such as growth stock funds, small-cap stock funds, index funds, and ETFs, in your taxable brokerage account.
IRS Publication 550 is where you'll find important information about the tax treatment of mutual funds and money market funds.
Pub 550 explains:
- what investment income is taxable and what investment expenses are deductible,
- when and how to show these items on your tax return,
- how to determine and report gains and losses on the disposition of investment property,
- and information on property trades and tax shelters.
The tax cost ratio measures the amount of annualized return the investor loses to taxes. For example, if a mutual fund's tax cost ratio is 2% and the return of the fund is 10%, the investor's net return after taxes is 8%. To find tax-efficient funds, you will look for low tax cost ratios.
Morningstar is a mutual fund research and analysis company that calculates and provides tax cost ratio. Here's how to find it on their site:
- Go to Morningstar.com.
- Enter the Ticker symbol at the top of the page.
- Now you are on the fund's "quote" page.
- Click on the "Tax" link on the toolbar directly beneath the fund name.
- Tax-cost ratio is on this page.
If you have other questions, don't be afraid to try the Internal Revenue Service website at IRS.gov. It's not quite as complex as you might think!
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as tax advice or investment advice. Contact a tax professional for the best guidance on your tax circumstances. Under no circumstances does this information represent a recommendation to buy or sell securities.