How mutual funds and taxes work
A mutual fund is an investment company that qualifies for special treatment under the tax law. That special treatment permits mutual funds to pay dividends that may include long-term capital gain or tax-exempt interest. To qualify for special tax treatment, mutual funds must comply with rules concerning the types of investments they make, the payment of dividends, and various other matters.
Mutual funds provide stock market access to the small investor, but they're not small businesses. The total amount held by mutual funds is measured in the trillions. And over a recent period, that number grew by more than a billion dollars per day.
You are a shareholder
Mutual funds are often explained as a way for small investors to pool their money together for investment purposes. You may be able to make deposits to and withdrawals from your mutual fund account in much the same way as you do with your bank account. So many investors start to think of their mutual fund account as sort of a glorified bank account, and lose sight of the following:
When you make a deposit to a mutual fund account you're buying stock in the mutual fund.
You may feel that you're an owner of whatever the mutual fund holds. In a loose sense that's true, but it's not really accurate. In reality you own shares of stock in a company (namely the mutual fund), and that company owns the investments. That changes the way you report the income.
Example: You invest in a mutual fund that holds corporate bonds. Most of the fund's income comes from interest payments on the bonds. But your income from this fund will be dividends, not interest.
There's a corollary that's even more important:
When you withdraw money from a mutual fund account, you're selling mutual fund stock.
You don't have to report anything on your tax return when you take money out of a bank account. (Any interest you receive is taxed when the interest goes into the account.) But when you take money out of a mutual fund account, it's a sale of stock. That means you have to report a sale on your tax return, usually reflecting a capital gain or loss. So there's a little more thought that should go into a withdrawal from a mutual fund account.
Mutual fund families
A mutual fund may be offered as part of a family of mutual funds that are under related management. The rules for your fund may make it easy to move money from one fund in the family to another. For example, you may be able to switch from the growth fund to the bond fund without paying fees that would otherwise apply. These transfers are taxable sales.
Many mutual fund investors believe they are merely transferring money from one account to another within a single company when they make such a transfer. That's not the case. When you transfer from one fund to another, you're selling one fund and buying the other. If the value of your shares in the first fund has increased while you held them, you'll have to report a capital gain on the sale. So don't make this type of transfer without considering the tax consequences first.
Special dividend rules
If you receive a dividend on regular stock, the dividend is almost always treated the same way: the entire dividend is taxable as ordinary income. Even if the only kind of income the company received was long-term capital gain, a dividend paid by a regular corporation must be reported as ordinary income. That's not true for mutual funds.
Special rules for mutual funds permit the tax treatment of certain types of income to "flow through" to the shareholders. If your mutual fund has a long-term capital gain, it can pay a capital gain dividend. You get to report this as a capital gain on your tax return, which may mean paying a lower rate of tax. Similarly, if a mutual fund receives tax-exempt interest on municipal bonds, it can pay you a dividend that is treated like tax-exempt interest. This "flow-through" treatment doesn't apply to all types of income. For example, if your mutual fund has a short-term capital gain, the dividend is treated as ordinary income. In most cases this doesn't make a difference, but you may have a situation where it would be better to treat this income as short-term capital gain. You're not allowed to do that.
Special rules for sales
When you sell mutual fund shares you can apply the same rules that apply when you sell shares in a regular corporation. But sales of mutual fund shares provide you with other choices. There are two different "averaging rules" that can be used to determine how much gain or loss you have on your sale. These rules call for some learning on your part, but once you get them down they can save you a lot of paperwork.
There's also a special rule for certain short-term capital losses. If you sell mutual fund shares six months or less after you bought them and incur a capital loss, you may be required to treat that loss in a special way depending on what types of dividends you received while you held the shares.
These rules combine to create certain timing issues with respect to mutual funds. In particular, it's often advisable to avoid buying mutual fund shares shortly before the fund pays its year-end dividend. The dividend doesn't make you any richer, because the value of the fund goes down by the amount of the dividend. But you still have to pay tax on the dividend.
It's always important to keep good records of your investment transactions. If you invest in mutual funds, it's doubly important. Without such records, figuring gain or loss when you withdraw money from the fund can be difficult at best.
A publication of Fairmark Press Inc. Copyright Kaye A. Thomas 1997 -