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Funds and Taxes... Page 2
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Tip: Many mutual fund investors
fall into this same trap every year and wind up overpaying taxes.
Let's say you invest $1,000 in a bond mutual fund and over the next five years you receive
a total of $200 in dividend income -- assume you pay tax on the dividends each year and
they are reinvested. You sell the fund and receive a check in the amount of $1,200 (your
original investment of $1,000 plus $200 in dividends). Your fund company sends a Form 1099
to the IRS stating gross proceeds of $1,200.
What amount will you pay taxes?
$1,200 minus $1,000 equals $200 -- right?
Actually -- you won't owe a dime because you've already paid taxes.
Remember, reinvested distributions become part of the cost basis -- the total
amount you've invested. In this case, you've invested $1,200 ($1,000 + $200 of reinvested
dividends) -- which exactly matches the gross proceeds.
Tax-Friendly
Can it be? Tax and friendly in one sentence. Well, believe it or not, some funds are more
"tax-friendly" than others. Included in this group are index funds, tax-managed
funds, and funds that utilize a "buy and hold" strategy. Their objective is the
same -- reduce an investor's exposure to taxes.
These types of funds normally have low turnover rates. Turnover rates are important
because they measure how frequent a fund manager trades -- and to what extent taxable
capital gains are generated and passed on to shareholders.
Tax-managed funds keep a rein on taxes by offsetting large capital gains with equal
amounts of capital losses -- this is called "loss harvesting". Investors may
also be charged a redemption fee for leaving the fund too quickly. This prevents
speculators from jumping in and out of the fund -- forcing the fund manager to sell shares
and generate taxable gains.
Your Total Return
If you're not careful, taxes will take a big bite out of your fund's total return. Good
recordkeeping and tax efficient funds are a few methods to help ease the tax burden.
As always, you should consult a financial planner or tax advisor for additional
information regarding taxes.
Next: The
Fund Directory
Dollar Cost Averaging
Socially Responsible Funds
Mutual Fund Calculators:
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• Should I sell before or after one
year?
• What is my return if I sell
now?
• When will I recover my
costs?
• How much do fees affect my
return? |
