Mutual Fund Tax Bite Can Be Bigger Than Bark


April 16 is nearly upon us. In honor of tax season, we're running an article series to help investors understand how mutual funds are taxed. In this first installment, we examine the basics with a general overview of the subject. Later this week, we'll look at how capital gains and the alternative minimum tax (AMT) work.[/:Author:]
Mutual funds are supposed to be easy for an investor. After all, you don't have to worry about stock picking: That's what the fund manager is for. But at tax deadline time, several factors can make reporting gains and losses from mutual funds a nightmare.

If you're living that nightmare right now, here are a few things to pay close attention to:

  • You should have received your tax reports in January or February. They consist of Form 1099-DIV, Dividends and Distributions, Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains, and a tax report from the mutual fund company or your broker.

  • If a mutual fund has long-term capital gains, it can designate part of its dividend as a capital gains distribution, which shareholders report as if it were their own long-term capital gain. But if a fund's dividend includes short-term gains, investors treat that portion of the dividend as ordinary income on their tax returns.

  • If you sold shares throughout the year, then your "cost basis" is the all-important figure. This is the amount of your original purchase. Say you put $10,000 into a fund and reinvested the dividends for five years, each quarterly dividend gets added to your basis, so at the end of the year you need to compute this figure. Your year-end statement will enable this, and some funds compute the basis for you.

    Adding distributions to your basis can actually minimize your tax obligation, however, if you decide to sell. Let's say you bought a share of a fund for $1, and a year later you receive a $4 short-term capital gains distribution. You now owe tax on that $4 at your normal income tax rate. Then, a few months later, you decide to cash out. The fund is now trading at $8 a share, and you will owe a 50 cent transaction fee on the sale. You'll only pay tax on $2.50 ($7.50 minus your $5 cost basis).

  • The more your fund trades, the more tax you will pay as long as you own the fund. Docile index funds generate the least obligations, but usually have higher taxes when you sell.

  • If you bought shares at different times and at different prices throughout the year, then things get even trickier. Fortunately Uncle Sam has made it a little easier by providing investors with averaging rules when filing their returns. Since most mutual fund investors don't hold the stock certificates representing their shares (which are usually left with their brokerage), if you sell some but not all of your shares, the tax law treats you as if you sold the first ones you acquired. This is called the "first-in, first-out" rule. You also have the option to follow the averaging rule, in which you add up your basis in a fund then divide by the number of shares to get an average basis per share. Any sales are considered to come from the oldest shares first when determining a loss or a gain. This is called the "single-category" method. Another averaging rule, the "double-category" method, allows you to identify whether you sold short-term or long-term shares.

Another bone of contention among fund investors is that most funds make their capital gains distributions in the month of December. So if you're going to skimp on Christmas and instead make a large fund purchase in the month of December, make sure you purchase the shares after the capital gains distribution has been made, cautions San Francisco CPA Wayne Dillon, or else you'll be paying capital gains taxes on a fund you've only owned for a couple of weeks.

Mutual fund taxation issues can be so bad that CBS MarketWatch columnist Paul Farrell suggests long-term investors get themselves one of two popular software programs, Kipliger's Tax Cut or Intuit's Turbo Tax. "Otherwise you'll have an absolute nightmare trying to reconstruct it later on," says Dr. Farrell.

With stocks, as long as you hold onto them you don't have to pay any capital gains taxes, but with mutual funds you have to reconcile with Uncle Sam every year. One doctor friend that Dr. Farrell knows got so peeved when prepairing his tax return this year that he has sworn off mutual fund investing for life. While he may be overreacting a bit, let's look at his particular situation:

Dr. X's medical practice barely broke even last year, and his mutual fund portfolio was down 20 percent. But because of activity on behalf of the fund manager, Dr. X was hit with a capital gains tax even though he had no income from the fund or his practice. "It was the worst of all possible situations," says Farrell. The man had no control over when he would take his losses - even though his fund was down at the end of the year, the fund manager had made profitable trades earlier in the year.

To maximize your tax efficiency, Farrell recommends index funds with low turnover, municipal bonds and bond funds, and tax-management funds.

Finally, financial expert Kaye Thomas notes that the new version of Form 1099-DIV makes it much easier to figure out what you need to know about capital gains distributions. But a common mistake is forgetting to fill out the tax computation on the back of Schedule D, so don't forget.