A basic knowledge of mutual fund taxation and careful record-keeping can help you cut the tax bite on your mutual fund investments.
You must generally report as income any mutual fund distributions, whether or not they are reinvested. The tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the fund's portfolio of securities. Thus, all dividends and interest from securities in the portfolio, as well as any capital gains from the sales of securities, are taxed to the shareholders.
There are two types of taxable distributions: (1) ordinary dividends and (2) capital gain distributions.
Capital gains rates. Two different sets of long-term capital gains rates apply for capital gains distributions and for sales of mutual fund shares during 2003, making an already complicated rule more complicated. The beneficial long-term capital gains rates on sales of mutual fund shares apply only to profits on shares held more than a year before sale. (Profit on shares held a year or less before sale is ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.)
Before 5/6/03. For capital gains distributions received before 5/6/03 and for gains on shares held long-term (more than a year) when sold before 5/6/03, the tax rate is 20% of net gain (except 10% if the taxpayer is otherwise below the 25% bracket). See also 5-year rule below.
After 5/5/03. For capital gains distributions received after 5/5/03 and for gains on shares held long-term (more than a year) when sold after 5/5/03, the tax rate is 15% of net gain (except 5% if the taxpayer is otherwise below the 25% bracket). The 15%/5% rates apply through 2008, except that the 5% rate becomes 0 in 2008. The rates revert to 20% and 10% (as before 5/6/03) in 2009 and 2010, with an 18% rate for certain assets held more than 5 years, see below.
A further complication, which works in taxpayers favor, is this: Say your taxable income, apart from long-term capital gains and qualified dividends, puts you in a tax bracket below 25% (thats below $56,800 on a joint return). In this case youll get the benefit of the lower rate (10% for pre 5/6/03 long-term gains, 5% for post 5/5/03 long-term gains and 2003 dividends whenever received) on the amount of gain between your taxable income and the start of your 25% bracket. See Examples below under Computing 2003 capital gains tax.
5-year rule. Taxpayers below the 25% bracket who sold, before 5/6/03, assets held more than 5 years qualify for an 8% capital gains rate on such sales. For sales after 5/5/03 and before 2009, the 5% rate applies (0 for 2008).
18% capital gains rate after 2008. Mutual fund stock gains otherwise taxable at a 20% rate after 2008 will be taxed at 18%, if the stock was acquired or treated as acquired after 2000 and held more than 5 years.
Stock whose ownership began before 2001 is treated as if acquired after 2000 if the taxpayer so elected. Under the election the taxpayer reported as if the stock was sold January 2, 2001 for its fair market value (FMV) on that date, and reported gain accordingly. The stock is then treated as acquired on that date, for that FMV.
The effect of the election is to lower by 2 percentage points (from 20% to 18%) the capital gains tax rate otherwise scheduled to return after 2008, at the cost of a current (2001) tax on paper gains. Since paying a tax in one year in order to obtain a tax benefit in later years seemed a questionable enterprise, this Financial Guide at the time urged caution in making the election. It has turned out that the election does no good for sales before 2009, where the tax rate has been reduced to 15% anyway. The election is irrevocable and no provision has been made to refund tax paid. The election will be useful, assuming no further law change, only for sales after 2008.
Mutual fund distributions are generally taxable in the year paid. At tax time, your mutual fund will send you a Form 1099-DIV, which tells you what earnings to report on your income tax return, and how much of it is post 5/5/03. Because tax rates on qualified dividends received after 2002 are the same as for capital gains distributions and long-term gains on sales after 5/5/03, Congress wants these items combined in your tax reportingthat is, qualified dividends added to long-term capital gains. Lest anyone think this makes reporting easier, remember that gains and distributions before 5/6/03 will not be included (meaning that such gains for the period 1/1/035/5/03 will be taxed higher than dividends received in that period). Also, capital losses are netted against capital gains before applying the favorable capital gains rates. Losses will not be netted against dividends.
Computing 2003 capital gains tax
2003 reporting problems. The 2003 Act didnt change the rules taxing some capital gains at 25 % (recaptured real estate depreciation) and 28% (collectibles and part of certain small business stock)but few individuals have such gains. The 2003 Act imposes several different tax rates in 2003 on the same person, for the same kind of transaction, depending on tax bracket, period held, and when during the year the transaction occurred. Official Washington is predicting massive taxpayer confusion, tax reporting complexities and mistakes, resulting from the capital gains changes.
Undistributed capital gains. Mutual funds sometimes retain a part of their capital gain and pay tax on them. You must report your share of such gains, and can claim a credit for the tax paid. The mutual fund will report these amounts to you on Form 2439. You increase your shares' "cost basis" (more about this in Tip No. 5, below) by 65% of the gain, representing the gain reduced by the credit.
Most funds offer you the option of having dividend and capital gain distributions automatically reinvested in the funda good way to buy new shares and expand your holdings. While most shareholders take advantage of this service, it is not a way to avoid being taxed. Reinvested ordinary dividends are still taxed (at long-term capital gains rates if qualified and received after 2002 and before 2009), just as if you had received them in cash. Similarly, reinvested capital gain distributions are taxed as long-term capital gain.
The "exchange privilege," or the ability to exchange shares of one fund for shares of another, is a popular feature of many mutual fund "families," i.e., fund organizations that offer a variety of funds. For tax purposes, exchanges are treated as if you had sold your shares in one fund and used the cash to purchase shares in another fund. In other words, you must report any capital gain from the exchange on your return. The same tax rules used for calculating gains and losses when you
The tax law requires that mutual funds distribute at least 98% of their ordinary and capital gain income annually. Thus, many funds make disproportionately large distributions in December. The date on which a fund's shareholders become entitled to future payment of a distribution is referred to as the ex-dividend date. On that date the fund's net asset value (NAV) is reduced on a per share basis by the exact amount of the distribution. Buying mutual fund shares just before this date can trigger an unexpected tax.
If you reinvest the $1,000, the distribution has the appearance of a wash in your account, since the value of your fund investment remains $10,000. The $1,000 reinvestment results in the acquisition of 111.1 new shares with a $9 NAV and increases the cost basis of your total investment to $11,000. If you were to redeem your shares for $10,000 (their current value), you would realize a $1,000 capital loss.
In spite of these tax consequences, it may be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date.
If you are in the higher tax brackets and are seeing your investment profits taxed away, there is a good alternative to consider: tax-exempt mutual funds. Distributions from such funds that are attributable to interest from state and municipal bonds are exempt from federal income tax (although they may be subject to state tax).
The same is true of distributions from tax-exempt money market funds. These funds also invest in municipal bonds, but only in those that are short-term or close to maturity, the aim being to reduce the fluctuation in NAV that occurs in long-term funds.
Many taxpayers can ease their tax bite by investing in municipal bond funds. The catch with municipal bond funds is that they offer lower yields than comparable taxable bonds. For example, if a U.S. Treasury bond yields 7.5%, a quality municipal bonds of the same maturity might yield 6%. If an investor is in a higher tax bracket, the tax advantage makes it worthwhile to invest in the lower-yielding tax-exempt fund. Whether the tax advantage actually benefits a particular investor depends on that investors tax bracket.
To figure out how much you would have to earn on a taxable investment to equal the yield on a tax-exempt investment, use this formula: Tax-exempt yield divided by (1 minus your tax bracket) = equivalent yield of a taxable investment.
Although income from tax-exempt funds is federally tax-exempt, you must still report on your tax return the amount of tax-exempt income you received during the year. This is an information- reporting requirement only and does not convert tax-exempt earnings into taxable income.
Your tax-exempt mutual fund will send you a statement summarizing its distributions for the past year and explaining how to handle tax-exempt dividends on a state-by-state basis.
It is very important to keep the statements from each mutual fund you own, especially the year-end statement.
By law, mutual funds must send you a record of every transaction in your account, including reinvestments and exchanges of shares. The statement shows the date, amount, and number of full and fractional shares bought or sold. These transactions are also contained in the year-end statement.
In addition, you will receive a year-end Form 1099-B, which reports the sale of fund shares, for any non-IRA mutual fund account in which you sold shares during the year.
Why is recordkeeping so important? When you sell mutual fund shares, you will realize a capital gain or loss in the year the shares are sold. You must pay tax on any capital gain arising from the sale, just as you would from a sale of individual securities. (Losses may be used to offset other gains in the current year and deducted up to an additional $3,000 of ordinary income. Remaining loss may be carried for comparable treatment in later years.)
The amount of the gain or loss is determined by the difference between the cost basis of the shares (generally the original purchase price) and the sale price. Thus, in order to figure the gain or loss on a sale of shares, it is essential to know the cost basis. If you have kept your statements, you will be able to figure this out.
One of the advantages of mutual fund investing is that the fund provides you with all of the records that you need to compute gains and lossesa real plus at tax time. Some funds even provide cost basis information or compute gains and losses for shares sold. That is why it is important to save the statements. However, you are not required to use the fund's gain or loss computations in your tax reporting.
Make sure that you do not pay any unnecessary capital gain taxes on the sale of mutual fund shares because you forgot about reinvested amounts. When you reinvest dividends and capital gain distributions to buy more shares, you should add the cost of those shares (that is, the amount invested) to the cost basis of the shares in that account because you have already paid tax on those shares.
Failure to include reinvested dividends and capital gain distributions in your cost basis is a costly mistake.
Sometimes mutual funds make distributions to shareholders that are not attributable to the fund's earnings. These are nontaxable distributions, also known as returns of capital. Because a return of capital is a return of part of your investment, it is not taxable. Your mutual fund will show any return of capital on Form 1099-DIV in the box for nontaxable distributions.
If you receive a return-of-capital distribution, your basis in the shares is reduced by the amount of the return.
Nontaxable distributions cannot reduce your basis below zero. If you receive returns of capital that, taken together, exceed your original basis, you must report the excess as a long-term capital gain.
Your overall basis will not change if non-taxable distributions are reinvested. However, your per-share basis will be reduced.
Calculating the capital gain or loss on shares you sell is somewhat more complicated if, as is usually the case, you are selling only some of your shares. You then must use some accounting method to identify which shares were sold to determine your capital gain or loss. The IRS recognizes several methods of identifying the shares sold:
Reports from your funds may include a computation of gain or loss on your sale of mutual fund shares. Typically, these will use the average cost method, single category rule. This is done as a convenience. You are allowed to adopt one of the other methods.
First-In, First-Out (FIFO)
Under this method, the first shares bought are considered the first shares sold. Unless you specify that you are using one of the other methods, the IRS will assume you are using FIFO.
This approach allows you to calculate an average cost for each share by adding up the total cost of all the shares you own in a particular mutual fund and dividing by the number of shares. If you elect to take an average cost approach, you must then choose whether to use a single-category method or a double-category method.
Keep in mind that once you elect to use either average cost method, you must continue to use it for all transactions in that fund unless you receive IRS approval to change your method.
Under this method, you specify the individual shares that are sold. If you have kept track of the purchase prices and dates of all your fund shares, including shares purchased with reinvested distributions, you will be able to identify, for example, those shares with the highest purchase prices and indicate that they are the shares you are selling. This strategy gives you the smallest capital gain and could save you a significant amount on taxes.
To take advantage of this method, you must, at the time of the sale or exchange, indicate to your broker or to the mutual fund itself the particular shares you are selling. The IRS also insists that you receive written confirmation of your instructions.
One way the IRS makes sure it receives taxes owed by taxpayers is through backup withholding. In the mutual fund context, this means that a mutual fund company is required to deduct and withhold a specified percentage (see below) of your dividend and redemption proceeds if one of the following has occurred:
Under the 2003 Tax Act, the backup withholding percentage is 28% in 2003 and after.
Many states treat mutual fund distributions the same way the federal government does. There are, however, these areas of different treatment:
If your fund invests in foreign stocks or bonds, part of the income it distributes may have been subject to foreign tax withholding. If so, you may be entitled to a tax deduction or credit for your pro-rata share of taxes paid. Your fund will provide you with the necessary information.
If you sell fund shares at a loss (so you can take a capital loss on your return) and then re-purchase shares in the same fund shortly thereafter, beware of the wash sale rule. This rule bars a loss deduction when a taxpayer buys "substantially identical" shares within 30 days before or after the date of sale.
Many investors who hold mutual funds directly may hold others through tax-sheltered accounts such as 401(k)s, IRAs, and Keoghs. Your aggressive high-turnover funds, and high income funds, should be in tax-sheltered accounts. These generate more current income and gains, currently taxable if held directly but tax-deferred in tax sheltered accounts. Own buy-to-hold funds, and low activity funds such as index funds, directly. With relatively small currently distributable income, such investments can continue to grow with only modest reduction for current taxes.
For some investors, the simpler approach may be to hold mutual funds personally (since dividends, capital gains distributions, and sales of mutual fund shares qualify for lower capital gains rates until 2009) and more highly taxed income (such as bond interest) in the tax-sheltered account.
* * * * *
As you can see, there are many tax pitfalls that await the unwary mutual fund investor. Professional guidance should be considered to minimize the tax impact.
Books And Other Publications
Government And Non-Profit Agencies
To illustrate the advantages and disadvantages of the various methods of identifying the shares that you sell, assume that you bought 100 shares of Fund PQR in January 1989 at $20 a share, 100 shares in January 1990 at $30 a share, and 100 shares in November 1999 at $46 a share. You sell 50 shares in June of this year for $50 a share. Here are your alternative ways to determine cost basis.
|© Copyright 2003 FSO Technologies, Inc. All rights reserved.|