Taxation Issues - Tax Consequences of an Investor's Activities

Mutual Fund Distributions and Taxation
Investors receive two types of earnings from investment company shares: dividends and interest from the securities held in the fund portfolio, or investment income, and capital gains that result from the sale of securities in the portfolio for a profit.

Investment income can be reinvested in the fund or paid in cash to the investor. Either way, it is taxable as ordinary income, depending on the investor's marginal tax bracket, except for qualified dividends, which are taxable at a maximum rate of 15% for ordinary income earners.

Capital gains are paid out when the portfolio manager makes sales in the fund portfolio or when the investor redeems shares of the fund at a capital gain, just as they would be incurred by selling a stock for a profit, for example.

  • Long-term capital gains result from the sale of assets that have been held for more than a year and are taxed at 15%.
  • Short-term capital gains are realized with the sale of assets held for one year or less; they are taxed as ordinary income - that is, at the percentage of the investor's marginal tax bracket.

 

Look Out!
Any dividends or capital gain distributions are generally taxable when made, regardless of whether the investor reinvests dividends or capital gain distributions or receives them in cash.

It is the investor's responsibility to report mutual fund dividends and capital gains to federal and state tax purposes. Typically the mutual fund will provide informational reporting on a form 1099, which can be used to complete the taxpayer's return.

Selling Mutual Fund Shares
The following information details all of the issues that must be taken into account for calculating the tax impact of selling mutual fund shares.

Tax Rates

  • Capital gains - this refers to income resulting from the appreciation of a capital asset (such as mutual funds and stocks). Capital gains are not realized until the asset is sold. Capital gains are classified as short-term or long-term:
    • Short-term - assets held for 12 months or less are considered short-term capital gains and are taxed at ordinary income rates.
       
    • Long-term - assets held for longer than 12 months benefit from reduced tax rates (based on your marginal tax bracket). Ordinary income earners pay  a capital gains tax rate of 15%, while those in who are considered to be high income earners pay 20%.
       
  • Dividends - prior to 2003, dividends were taxed at ordinary income rates along with bond interest. Due to a change in tax law, "qualified" stock dividends (common and preferred) are now taxed like capital gains, with a maximum income tax rate of 15%. REIT dividends do not qualify for this special treatment.

Holding Period
Since the difference between short-term capital gains and long-term capital gains taxation rates is so significant, it is crucial to understand exactly when a security is considered purchased and when it is considered sold.

The holding period begins the day after the security is purchased (not the settlement date). The holding period ends the day of the sale. It is important to keep detailed records of these dates, to ensure that a security is not sold too soon.

If mutual shares were purchased on more than one date, there are several ways to calculate the cost basis of the shares sold:

  • Specific identification - the investor may choose to sell specific shares in order to minimize or maximize cost basis and therefore capital gains (or losses).
  • First-in/first-out - if the investor did not specify which shares were sold, the IRS presumes that the shares held longest were sold first.
  • Average share cost - this is the method used when selling all shares at once.
Calculating Gains and Losses
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