Beware the Mutual Funds' End-of-the-Year Tax Trap
- Wednesday, November 30, 2011
November and December are the most dangerous months of the year for tax-conscious investors.
In the process of investing, mutual funds incur capital gains and losses, and receive dividend and interest income on their investments. From a tax point of view, all of this is done on behalf of their shareholders. It's as if you owned all the investments outright, and the gains and losses that result are all your personal gains and losses.
There are three ways this happens:
- Funds invest in stocks that pay dividends. They collect the dividends and pay them out to you periodically.
- Funds invest in bonds or other debt securities that pay interest. They collect the interest and pay it out periodically.
- Funds sell one of their investments for more than they paid for it, thereby making a capital gain. They keep track of these gains (and offset them against any capital losses), and pay them out to you periodically, usually annually.
All of these payments to you are called "distributions." The fund decides whether to make these periodic distribution payments monthly, quarterly, semiannually, or annually — but most of the time they occur near the end of the calendar year. The amount you receive depends on how many shares you own.
A fund goes through a two-step process in making distributions. First, it "declares" the amount of the distribution it intends to make, and sets aside the appropriate amount of cash that will be needed to write you a check. This has the effect of suddenly lowering net asset value of the fund — one day the money was being counted as part of the fund, and the next day, the day of the declaration, it wasn't. The date this happens is called the "ex-dividend" date, and is the significant date as far as your taxes are concerned.
The second step of the distribution process is when the fund actually mails your check. This is called the "payment date" and is important only because that's when you finally receive the cash that's been promised. The payment date has no significance when computing your taxable income. Let's look at two common misconceptions that investors have about fund taxation.
Misconception #1: "As long as I don't sell any of my mutual fund shares, I won't have any capital gains taxes to pay."The mutual fund, within its portfolio, is continually buying and selling securities. Each time it sells one, it has another capital gain or loss. Since the tax law considers all of this as being done on your behalf, you participate in your fair share of that gain or loss at the time the fund declares a capital gain distribution.
When you eventually do redeem (sell) your fund shares, any capital gain or loss from the original purchase must be reported on Schedule D of your form 1040 tax return just like any other investment. One easy way to put off paying this kind of capital gains tax is simply to avoid selling mutual funds for gain just before the end of the year. If you sell in December, then taxes will have to be paid by April 15, just three and a half months later. Instead, you might wait to sell until the first week of January. The tax on such gains would then not be owed until April 2012. By the same token, a good time to sell a fund if you have a loss is in December, as the loss will be deductible on the tax return filed only a few months later.
Misconception #2: "It's a good idea to invest in a mutual fund just before one of its periodic distributions."Actually, it's a bad idea because it will create an immediate tax liability for you. If an investor buys a fund today and the fund declares a distribution tomorrow, the investor owes tax on the amount of the distribution. There is no actual profit in owning a fund on the day it goes ex-dividend because the amount the shareholders are to receive is deducted from the value of the fund that same day.
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