Investing in a taxable account using mutual funds is particularly tricky at the end of the year. An investor should evaluate the performance and expenses of any fund under consideration and look at potential tax liability. One advantage of investing in individual stocks is having control over capital gains. Capital gains are not taxable until the stock is sold. The decision to sell is entirely up to the shareholder. However, capital gains could be realized from a mutual fund before it is sold. The shareholder pays tax on capital gains when shares are sold and could owe tax when the mutual fund declares capital gains. The capital gains reported by the fund are based on the sale of positions held within the fund. Tax law requires the fund to pass on those gains to its shareholders.
There are two pieces of tax information you need to consider when evaluating a fund:
- Realized gains – this is the amount of capital gains realized internally by the fund, but not yet distributed. An investor who buys shares of the fund before gains are distributed could pay tax on gains they didn’t earn. Check the fund’s website to see if gains have been declared and when they plan to distribute them. Waiting until the fund goes ex-dividend to buy shares in a taxable account can avoid a taxable distribution. A second option is to buy the fund in a retirement account or Roth IRA. Capital gain distributions are not taxable in these types of accounts.
- Unrealized capital gains – this is the capital gain in the fund that has not been realized. These gains could become taxable if the fund sells some of the appreciated positions before the end of the year. There is really no way to know whether this will happen. Passively managed funds (like index funds) are less likely to realize gains unless there is a run of massive redemptions, forcing the fund to liquidate stocks to payout distributions.
There are several precautions investors should take to avoid the unpleasant surprise of a mutual fund capital gain distribution. Start by doing some homework. Most funds begin forecasting distributions in October. Email the fund for information if you can’t find anything posted on their website.
Morningstar includes information on unrealized gains on the funds they follow. The information is listed as a percentage under potential capital gains exposure. Investors may want to stick with exchange-traded funds and index funds that are relatively tax-efficient when choosing investments for taxable accounts. Save actively managed funds and those that are less tax-efficient for retirement accounts. Turnover is also an important indication of how tax-efficient a fund is likely to be. Funds with high turnover should be held primarily in retirement accounts.
When funds report distributions, they classify them as long-term capital gain, short-term capital gain, or a regular dividend. The shareholder reports the long-term capital gain on Schedule D of their tax return and the rest as either qualified or non-qualified dividends.
The long-term capital gain is treated the same as if the investor personally entered a transaction that produced the capital gain. A taxpayer could use realized losses from other trades to offset the mutual fund gain. The tax rate on the capital gain distribution depends on the taxpayer’s bracket.
Capital Gains Rates for the 2020 Tax Year
|FILING STATUS||0% RATE||15% RATE||20% RATE|
|Single||Up to $40,000||$40,001 – $441,450||Over $441,450|
|Married filing jointly||Up to $80,000||$80,001 – $496,600||Over $496,600|
|Married filing separately||Up to $40,000||$40,001 – $248,300||Over $248,300|
|Head of household||Up to $53,600||$53,601 – $469,050||Over $469,050|
Higher rates apply to some special categories of long-term capital gain, such as the sale of gold. The IRS categorizes gold and other precious metals as “collectibles,” which are taxed at a 28% long-term capital gains rate. Investors who own shares of mutual funds containing these types of investments may have taxable capital gain distributions subject to the collectibles tax rate.
Taxpayers with higher incomes could also be subject to the Medicare surtax on capital gain distributions. The surtax is 3.8% on the lesser of net investment income or modified adjusted gross income (MAGI) over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. The effective tax rate for these taxpayers becomes 18.8% or 23.8%.
Investing in mutual funds for a taxable account towards the end of the year requires a few extra steps. However, extra care could save needless taxes on April 15.
- Taxpayers should exercise care when buying funds at the end of the year to avoid paying tax on gains earned internally by the fund.
- Fund research should include information on realized and unrealized gains within the fund.
- The turnover rate of a fund is a good indicator of how tax-efficient the fund will be going forward.