Mutual funds offer an uncomplicated way to invest in a diversified portfolio compared to buying individual stocks and bonds. But the tax treatment of mutual funds is not always simple.
How are mutual funds taxed?
The sale of mutual funds that have gone up in value is a taxable event. If the value goes up or down but there is no sale, then there is no taxable income or loss. The structure of the tax rates that the profit is taxed on depends first on how long the fund was held for. This is also true for other common investments, like individual stocks or ETFs.
If the investment has been held for less than one year, the profit is taxed using the ordinary rate structure. These are the same rates income sources like wages, interest, and rents are taxed at. These rates can be as high as 37%.
If the investment has been held for over one year (one year would be short term), then a special set of tax brackets apply. These are known as the long-term capital gains rates. Most commonly the income will be taxed at 15%, but there is a 0% bracket or up to a 20% bracket for high earners.
Capital gains also occur when a mutual fund portfolio manager sells shares of a stock held in the portfolio at gain from the price he/she bought them (called realized capital gains). When the latter happens, the mutual fund must pay out those capital gains, at least once a year, to satisfy federal tax requirements. This payout is called a “distribution,” and it is paid to each shareholder on a pro-rata (equally portioned) basis. Shareholders can choose to receive distributions in cash or reinvest them into their account. Even when distributions are reinvested, shareholders pay taxes on the amounts they receive (unless their assets are held in a tax-advantaged account, such as a traditional IRA or a Roth IRA).
Many investors are often surprised when they receive their year-end Mutual Fund tax statement (1099s) and see a significant Capital Gains amount, despite the fact they had not sold any shares of the fund during the tax year. Capital Gain Distributions occur when the mutual fund manager decides to sell assets within the fund during the tax year. Such a sale may be due to the changing market outlook, to maintain the fund’s stated allocation, or to raise funds for shareholder redemptions. Mutual Funds must distribute at least 95% of its gains from these sales to the fund shareholders, which will result in unplanned capital gains for shareholders. Unfortunately, these distributions (often reinvested back into the fund) often occur in November and December and can make capital gain planning a little trickier.
An additional complication is the additional 3.8% net investment income tax. Taxpayers with modified adjusted gross incomes over $200,000 (or over $250,000 for joint files) have to plan around this tax. If income from investments—such as sales of mutual funds or other securities, dividends, or interest as common examples—is present, even long-term gains can be taxed up to a combined 23.8%.
With proper planning, sales of investments can be timed to avoid pushing income high enough to be subject to this additional tax.
When does a sale occur and how is the profit determined?
In most cases, it is obvious when a sale occurs. But there can be some pitfalls specific to mutual funds, such as swapping funds within a fund family. No cash is received from the sale, but it is considered that the first fund is sold. When you are close to going to the next tax bracket or being subject to the net investment income tax, this requires careful planning. The amount of profit or loss is determined by taking the difference between the sale price and the tax basis.
For mutual funds and other publicly traded securities, the tax basis will be known to the brokerage company where the assets are held in, and this is relatively simple. Specific shares can then be sold to avoid undesirable outcomes, like short-term capital gains or net investment income tax.
Complications can occur. One common situation involves inherited mutual funds or other securities. In that case, there is what is called a step up in basis, and this increases the tax basis to the fair value on the date of the decedent’s passing. The impact of this is to erase any gains from the time it had originally been purchased up until the time the original owner passed. Brokerage firms may not update for this unless informed, or this may require some work to look up prices to adjust the basis reported with the tax return. Not taking advantage of this can result in a significant amount of unnecessary tax.
More to consider
There are other situations besides what has been discussed already. For example, states like Wisconsin allow a 30% exclusion of long-term capital gains, but short-term gains are included in income in full. Other states tax everything at the same rate and do not have provisions for long-term gains, while others can have an even more generous benefit than Wisconsin.
The best course of action is more, rather than less communication. Both between the taxpayer and any investment fund managers, working alongside your tax professional. Wegner CPAs is happy to assist and has experience with planning related to this and other aspects of each person’s unique tax situation.
