There are some tax downfalls linked with trading mutual funds that should be given consideration. Awareness of these downfalls will reduce taxes and stop surprises from happening while visiting your CPA firm.
One thing to be aware of is, that it is possible to sell a mutual fund unknowingly or what one client called a “Stunner” sale. This may arise if your mutual fund has an option to issue checks out of your investment in the fund. Whenever checks are deducted from the investment, a partial sale of the investment is being executed. A taxable gain or deductible loss arises from each check written, with the exception of funds that have shares that are always one dollar values (e.g. money markets). Furthermore, each sale needs to be listed on the annual income tax return as a line item.
Some clients are also surprised when taxable sales results from rebalancing the portfolio of fund investments. Most mutual funds allow investors make modifications and allocate the way the account is invested. Rebalancing and reviewing an investment portfolio is a basic principle of money management. The rebalancing and transferring of money from one mutual fund to another mutual fund is a taxable sale of the mutual fund that was transferred.
Maintaining records is also important. Investors should save all the official tax receipts and correspondence such as Form 1099-DIV, statements and trade confirmations. The statements are helpful when the time comes to calculate the costs of investments that have been sold. Most fund companies allow investors to reinvest their dividends to purchase additional shares or fractional shares when the dividend is paid. These documents are necessary to calculate the amount of taxable gain or deductible loss when the investment is sold. This paperwork has extra valuable during an IRS audit. Some clients receive statements at the end of the year with comprehensive lists of all the transactions for the year, we usually recommend keeping the annual statements and discarding the other accounts statements received during the year. Always save the envelopes that say “tax information inside.”
In 2011 record keeping requirements were cut down and streamlined. New rules make it necessary for mutual fund companies to track all gains or losses on investments sold by the company and to provide this information to investors. The company must also report whether the gains and losses are short or long- term.
For the investments purchased before 2011, the mutual fund companies usually give investors all the information they have available to facilitate calculating any gain or loss on the sale of the fund.
Timing is another concept to consider. Gains distributions can be a bad thing believe it or not. As a general rule, investors should avoid purchasing a fund close to the capital gain distribution or dividend date. The dividend is taxable and increases an investor’s tax liability. These payments increase the tax in spite of the fact; the money is being reinvested in new shares. On the other hand, an investor maybe considering selling a mutual fund near the end of the year, and should weigh out the tax and non-tax implications of the sale in the current year versus a sale in the succeeding year. The sale in succeeding year transfers the gain or loss to the next tax year.
Long term investors should also assess which shares of the same investment should be held and which should be sold. There are guidelines in identifying such shares and following the guidelines can reduce tax. One way reduce tax is to identify shares that have been held longer than one year and qualify for the more preferable long-term capital gain rate. Another way to save on taxes is loss harvesting, for example, suppose Karla owns 100 shares of Google. She bought 40 shares at $40 per share, 30 shares at $80 per share and the remaining 30 shares at $50 per share. Karla then sells 30 shares at $70 per share. Specifically identifying the shares, Karla can match the shares she sold with the 30 shares she purchased for $80 per share, generating a tax loss.