Investing in a taxable account is particularly tricky at the end of the year when you are using mutual funds. Not only do you need to evaluate the performance and expenses of any fund you are considering, you also need to look at potential tax liability. One advantage of investing in individual stocks is the control you have over paying taxes. You don’t have to pay tax on your gains as long as you don’t sell the stock. Taxes are due when you sell which is entirely your decision to make. This is not the case with mutual funds. You will have to pay tax on gains if you sell your fund shares, but you can also end up paying taxes on capital gains when you don’t sell. When the mutual fund sells some of its holdings internally, it’s required by law 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 capital gains that have been realized but not yet distributed by the fund. If you buy shares of the fund before the gains are distributed you could end up paying tax gains you didn’t earn. Check the fund’s website to see if gains have been declared and when they plan to distribute them. You should wait until the fund goes ex-dividend to buy shares in a taxable account. Buy the fund in your retirement account or Roth IRA if you really like the fund and don’t want to wait for the dividend to be paid.
- 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 pay meet distributions.
You can do several things to avoid the unpleasant surprise of a mutual fund capital gain distribution. Start by doing your 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 in the data they provide on the funds they follow. The information is listed as a percentage under potential capital gains exposure. You may want to stick with exchange-traded funds and index funds that are relatively tax-efficient when choosing investments for your taxable accounts. Save actively managed funds and those that are less tax efficient for your retirement accounts. Turnover is also an important indication of how tax efficient a fund is likely to be. Funds with high turnover should only be held in retirement accounts.
When funds report their distributions they will classify them as a long-term capital gain, short-term capital gain or 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.
This long-term capital gain is treated the same as if you personally entered into a transaction that produced the capital gain. You can use realized losses from other transactions to offset the mutual fund gain. The tax rate on the capital gain distribution depends on your tax bracket. A long-term capital gain is generally taxed at 15% if your tax bracket is 25% or higher. If the gain falls into the 15% or 10% tax brackets, it’s taxed at 0% through 2012. Higher rates apply to some special categories of long-term capital gain such as the sale of gold. Beginning in 2013, the new Medicare tax will apply to capital gains for high income taxpayers.
- You must exercise care when buying funds at the end of the year to avoid paying tax on gains you didn’t earn.
- Your fund research should include information on realized and unrealized gains.
- The turnover of a fund is a good indication of how tax efficient the fund will be going forward.