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How Are Mutual Funds Taxed?
Many people have heard the Benjamin Franklin quote, “In this
world nothing is certain but death and taxes.” Mutual fund taxes can be
onerous. However, if you understand the complexities of mutual fund taxes
and are prepared when tax season comes around, you may be able to lessen the
blow.
Dividends and Capital Gains
The first thing to remember is that you generally must report
any mutual fund distributions as income. Even if you reinvest your profits,
the federal government still views this as personal income. Your mutual fund
will send you a Form 1099-DIV describing what earnings to report on your
income tax return. There are two main ways that mutual funds are taxed:
dividends and capital gains.
Dividends represent the net earnings of the fund and will
have a low tax rate of 15% (5% for those in tax brackets below 25% and 0%
for the same individuals in 2008 through 2010) if they are qualified.
Qualified dividends, with some exceptions, are dividends received from
domestic and foreign corporations after 2002 and before 2011. Foreign
dividends must be securities that are traded on U.S. exchanges or have IRS
approval.
Capital gains are profits from investor trading or
distributions given to shareholders after revenue is taken in from the fund
manager’s sales of securities. Provisions in the tax law allow you to pay
lower capital gains taxes on the sale of assets held more than one year.
These are referred to as “long-term” capital gains.
The maximum long-term capital gains tax rate is 15% (10% for
individuals below the 25% tax bracket, 0% for the same individuals in 2008
through 2010). Short-term gains — those resulting from the sale of assets
held less than one year — are taxed at your highest federal income tax rate.
This means that if you’ve been buying shares in a stock or
mutual funds over the years and are considering selling part of your
holdings, your tax liability could be significantly impacted by the timing
of your sale.
The low tax rates on long-term capital gains and dividends
are set to expire in 2010 unless extended by Congress.
Tax-Exempt Funds
One way to protect yourself from high mutual fund taxes is by
utilizing a tax-exempt fund. Distributions from these types of funds are
attributable to interest from state and municipal bonds, so they are exempt
from federal income tax (not necessarily state tax).
Investing in mutual bond funds can lessen the blow of taxes,
but it’s important to remember that they may offer lower yields than
comparable taxable funds. If you are in a high tax bracket, the tax benefits
may make it advantageous for you to invest in lower-yielding tax-exempt
funds.
Mutual fund taxes can be cumbersome, but there are ways to
make sure you are paying as little as possible. Remember that there are
always tax-advantaged accounts that you can utilize, such as IRAs or
401(k)s, to defer taxes until you withdraw funds in retirement. You may want
to consider tax-deferred accounts for high-income funds that come with lofty
tax rates. Regardless of how you handle your mutual funds, be sure to
consult with a tax professional.
The value of stock and mutual fund shares fluctuates. Shares,
when sold, may be worth more or less than their original cost.
Mutual funds are sold only by prospectus. Please consider
the investment objectives, risks, charges, and expenses carefully before
investing. The prospectus, which contains this and other information about
the investment company, can be obtained from your financial professional. Be
sure to read the prospectus carefully before deciding whether to invest.
© 2007 Emerald Publications
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