| Investments / Investing in mutual funds |  |
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A complex set of tax rules need to
be considered when making decisions about when to invest, what type of
fund to invest in, dividend options, switching between funds within a
mutual fund family, and selling shares. What type of fund.
There are literally thousands of mutual funds that you can choose from
to invest in. The choice of fund generally narrows based on one's
investment preferences and goals, e.g., high current yield income,
long-term appreciation, or tax-free income. These considerations are
generally the same as would be applied in making a direct investment in
corporate stock, bonds, etc. As among the choice of funds, if you
have unused capital losses carried over from an earlier year, you might
prefer to invest in a fund whose objective is capital appreciation
rather than current income. Capital gain distributions by the fund can
be offset by the loss carryover so that in effect the distribution is
tax-free. If your income puts you in a high tax bracket, you might want
to select either a fund seeking capital appreciation (to take advantage
of the favorable rates on long-term capital gains) or a tax-free bond
fund. However, it's important to remember
that regardless of the type of fund selected, distributions from any
fund, even a so-called tax-free bond fund (see below), can have
unanticipated tax consequences to the investor. When to invest.
A purchaser of mutual fund shares owns a proportionate share of all of
the fund's investment holdings, including, in addition to the stock and
bonds that comprise the fund's portfolio, any accrued but undistributed
interest or dividend income and capital gains earned by the fund. If you
buy mutual fund shares shortly before a dividend distribution, you may
be buying a tax liability. The share price you pay reflects this income
right. Say for example that you buy 1,000 mutual fund shares for $10 a
share shortly before the fund declares and pays a dividend of $2 per
share. As a result of the dividend, the per share price will drop to $8.
More important, you will have to include the $2,000 ($2 x 1,000)
dividend in your income (regardless of whether you receive the dividend
in cash or reinvest it in additional fund shares) even though there has
been no increase in the overall value of your investment. If the
investment had been delayed until after the dividend. the same $10,000
investment would have purchased 1,250 shares (at $8 per share) and this
problem of phantom income would have been avoided. Nature of fund distributions.
A mutual fund or regulated investment company (the more formal name for
these investment vehicles) is generally taxed as a conduit. They
distribute all or most of their income to shareholders. These
distributions can take the form of ordinary dividends, capital gain
distributions, tax-exempt-interest dividends, and distributions that
represent return of capital. A mutual fund shareholder will receive a
Form 1099-DIV from the fund showing the total amount distributed and
providing the information necessary to properly report those
distributions on the shareholder's income tax return. It's worth noting
that a fund that invests solely in tax-exempt municipal bonds may
nonetheless generate taxable income. If the fund has realized a profit
on the sale or disposition of such bonds, the resulting capital gain
will be distributed and taxed to the shareholders. Note also that a
mutual fund does not pass its losses through to its shareholders, it
just uses them to net against gains, with excess losses carried to other
years. The fact that the investor may
choose to receive his distribution in additional shares in the fund
(rather than in cash) does not affect the immediate tax consequences. A
dividend reinvestment option is treated as if the investor had received
the distribution in cash and then used the cash to acquire additional
shares. These new shares have a basis equal to their cost, i.e., the
amount of the dividend that was used to purchase them. An investor who makes specific
direct investments in stocks or bonds can generally control when and to
what extent to realize capital gains. This is not true to the same
extent with mutual fund investments. If a fund's investment portfolio
has done well in a given year, the fund may make a large distribution
near the end of the year because of gains that it has realized. These
will be taxed to the investor as ordinary dividend to the extent of
short-term gains, and capital gain distribution to the extent it
represents long-term gains of the fund. Because the fund may wait until
late in Dec. before announcing the amount that it is distributing,
year-end tax planning can be more difficult for individuals with
substantial mutual fund holdings. So-called "index funds"
offer a way to avoid most of the problems associated with capital gain
distributions. Index funds generally invest in the stocks or bonds that
make up some market index, e.g., the Standard and Poor's 500. They
remain fully invested in the component elements of the underlying index
so that the price of the fund tracks the movement of the index. These
funds generally do not sell any of their holdings unless necessary to
provide funds for shareholder redemptions or to adjust for changes in
the components of the index. As a result, these funds generally do not
realize significant capital gains and their capital gain distributions
are correspondingly low. Instead, appreciation in value is reflected in
the price of the fund's shares and is only translated into capital gain
when the investor chooses to sell.
Even if you do not invest in index
funds, you should be able to minimize tax costs by checking several
factors in the financial information made available by the fund in which
you are considering investing. First, check the fund's portfolio
turnover rate (the reciprocal of its average holding period for its
stocks). The longer the fund tends to hold its investments the lower its
turnover rate and the less likely it is for the fund to be distributing
taxable gains to its shareholders. Next, check the fund's net realized
gain. This is the amount of gain the fund has realized since its last
distribution. Finally, check the unrealized appreciation in the fund's
holdings. This represents the gains the fund will realize as it sells
its investments. By investing in funds with low portfolio turnover and
comparatively lower realized and unrealized gains, you should be able to
minimize the tax cost of your mutual fund investments. In order to properly determine
basis, see below, proper recordkeeping with respect to reinvestment of
fund distributions is very important. Sale of fund shares.
When an investor in a mutual fund sells some or all of his shares, gain
or loss is recognized. The gain or loss is measured by the difference
between the amount realized from the sale of the fund shares and the
basis for those shares. One difficulty with mutual fund investments is
that certain transactions are treated as sales even though they might
not normally be thought of as such. Another problem can arise in
determining your basis for shares sold, particularly if you are selling
only a portion of your fund holdings and the shares were acquired at
different times and at different prices. What is a sale.
No one is likely to dispute the fact that a sale occurs when an investor
has all of his shares in a mutual fund redeemed and receives a check for
the proceeds. Similarly, there is a sale if the investor directs the
fund to redeem the number of shares necessary for a specific dollar
payout, e.g., sufficient shares to produce a payout of $5,000. A less obvious sale occurs if you
are merely swapping funds within a fund family, for example the
surrender of shares of the X Income Fund for an equal value of shares of
the X Growth Fund received in exchange. Even though no money passes
hands, this is treated as a sale of the X Income Fund shares. Many mutual funds provide check
writing privileges to their investors. This is often a convenient and
speedy way to pay large bills (as compared to directing the fund to
redeem shares and send you a check, which then must be deposited in your
regular checking account and clear before you can draw against it).
However, each time you write a check on your fund account you are making
a sale of shares in the fund. Do this 20 or 30 times a year and you are
going to have a fairly complex capital gains schedule attached to your
income tax return. Determining basis of shares sold.
If an investor disposes of all of his shares in a particular mutual fund
in a single transaction, determining basis is relatively easy. Simply
add the basis of all the shares, i.e., the amount of actual cash
investments (including any commissions or sales charges) plus
distributions by the fund which were reinvested to acquire additional
shares less any distributions that represented a return of capital. The calculation becomes more complex
if the investor is disposing of only a portion of his interest in the
fund and the shares were acquired at different times and at different
prices. Taxpayers can use one of several methods to identify the shares
sold and determine their basis. . . . First-in first-out method. The
basis of the earliest acquired shares is used as the basis for the
shares sold. If the share price has been increasing over the period of
ownership, the older shares are likely to have a lower basis and thus
result in more gain. . . . Specific identification
method. You can specify to the fund at the time of the sale the
particular shares to be disposed of, e.g., "sell 200 of the 300
shares I purchased on July 1, Year 1". You must receive written
confirmation of your specification from the fund. This method often can
be used to lower the resulting tax liability by directing the sale of
the shares with the highest basis. . . . Average basis. IRS permits you
to use the average basis for shares that were acquired at various times
and that were left on deposit with the fund or a custodian agent. Under
the single category method, you find the average cost of all of your
shares regardless of how long you owned them. In applying the long-term
and short-term rules, shares are considered to be sold in the order in
which they were acquired. This method gives the investor less
flexibility in choosing which shares to dispose of, but is relatively
simple to apply. An investor can also use a somewhat more complex double
category method which determines the average basis for two separate
groups of shares, those held long-term and short-term holdings. As with
the specific identification method, above, the investor specifies from
which category the shares are to be sold. As should be apparent, mutual fund investments raise a multitude of potential tax problems. |
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