Mutual Funds – A Taxing Situation

Around tax time, we often hear this: “Why do I have to pay taxes on my mutual funds when all of the dividends and capital gains are reinvested?” The answer is that the IRS treats these distributions as income the same as it considers wages, salaries, tips, and even interest on bank accounts to be income. Owing taxes as a result of owning mutual funds can be confusing.

Income tax considerations related to mutual fund ownership are triggered in three basic ways. First, there is the payment of dividends to shareholders by the mutual fund. Most people think that dividends are generated by the mutual funds themselves, but a mutual fund is merely a shell that holds investments of individual stocks and bonds. So, in order for a mutual fund to make a dividend payment, an investment inside the mutual fund must have paid a dividend. This is why on average, bond funds pay more in dividends than stock funds. Let’s assume that we own shares of XYZ Mutual Fund, and XYZ Mutual Fund owns a $10,000 Treasury bond paying 4% annually, and 1,000 shares of Exxon Mobil Corporation which pays an annual dividend of $1.28 per share. The resulting annual dividends paid to XYZ would be $400 from the Treasury bond and $1,680 from the Exxon Mobil stock for a total of $1,680. These dividends are paid by the securities directly to the mutual fund. Even when the fund manager decides to invest these proceeds into other securities inside the fund’s portfolio, by the end of the year the fund must declare a dividend of $1,680 to its shareholders. If there are 2,000 shares of the XYZ Fund outstanding, and we own 200 of those shares, then our dividend would amount to $168. We would have the option of taking this dividend in cash or reinvesting it to purchase more shares of the fund. In either case, we would be responsible for paying taxes on income of $168.

Another situation that triggers tax consequences is capital gains generated within the fund. These capital gains are somewhat similar to dividends, but are more prevalent in stock funds than in bond funds. Capital gains are generated when the mutual fund manager sells a security held in the fund’s portfolio. For example, if the fund purchased 1,000 shares of Widget Corporation for $10 per share and then sold the shares for $25 per share, a capital gain of $15,000 would occur. As with dividends, the manager has the opportunity to reinvest the proceeds back into the fund’s portfolio, but a capital gain must be declared and paid to the fund’s shareholders by the end of the year. These capital gains are treated as either short-term or long-term by both the fund and the fund’s shareholders depending on whether the investment was held for less than or more than one year.

Finally, tax consequences can be generated when a shareholder sells shares of the mutual fund he directly owns. To calculate this type of capital gain, some work needs to be done by the shareholder. For example, if he bought 1,000 shares of XYZ Fund for $5,000 and then sold the entire position for $6,000, there would be a capital gain of $1,000, right? The answer is, maybe. The original cost basis is $5,000 with sales proceeds of $6,000. If there were no reinvested dividends or capital gains, then the capital gain generated would be $1,000. However, any reinvested dividends and capital gains along the way are added to the cost basis. So if $250 in dividends was reinvested and there were capital gains of $300, the cost basis would be $5,000 plus $250 plus $300 totaling $5,550. In this case, the sale would have resulted in a capital gain to the shareholder of $450 (proceeds of $6,000 less the total cost basis of $5,550).

The capital gain issue resulting from this sale can be more difficult to calculate if we liquidated only a portion of our total shares that we held in the XYZ Fund. The calculation would not be as simple as adding all purchases and reinvested dividends and capital gains and then subtracting from the proceeds. If we did not sell all of our shares, we must calculate the cost basis on just the shares we sold. This can be done using the average cost per share, or specifically identifying the shares that were sold. If specific identification is used, then we must use the first-in, first-out (FIFO) method for determining which shares were sold. Since the specific identification method requires very detailed recordkeeping, most mutual fund families report capital gains to shareholders using the average cost method.

Another common question that we hear is whether a capital gain is triggered when shares are transferred from one fund to another fund within the same mutual fund family. The answer is yes. The IRS considers each mutual fund to be a separate investment company. Therefore, even though the transferred investment stays within the same fund family, it is considered a sale of the original fund’s shares and a purchase of the second fund’s shares.

This article should not be considered the final source regarding taxes related to mutual funds. There are many other scenarios which could take us into much greater detail. Our intent is to provide a broad illustration of the tax issues that can result from owning mutual funds. If you have additional questions, please contact your financial consultant or your accountant.