How to Determine Taxes on Mutual Funds

Published By: Chad Silver
Last Updated: February 23, 2022

See More in: Stocks & Investment Accounts, Tax Education

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If you are a mutual fund investor, you most likely have numerous questions on the best way to calculate taxes on mutual funds. Yes, most investors know that taxes are paid on mutual fund earnings, but there is more to this general rule. Usually, the way your mutual funds are treated for tax purposes will depend on the type of investments within the fund’s portfolio.

This guide will help simplify some of these tax issues for you, covering what you need to know about mutual fund taxes and what to do to avoid unpleasant surprises when it comes time to file yours.

How Mutual Funds Generate Income

Mutual funds have been deemed to be one of the most successful investment mediums available due to their low cost, flexibility, and high chance for returns. When a person invests in a mutual fund, they do not pay money into a certificate of deposit (CD) or a savings account.

Instead, they are buying shares of stock in a company. That is why mutual funds are referred to as the business of “investing in securities.” As a mutual fund investor, you can make money in one of three ways:

1. Dividends or Stocks and Interest

Income is earned from dividends on stocks and interest on bonds that are held in the fund’s portfolio. Usually, funds give the investor an option to either reinvest the earnings and get more shares or receive a check for distributions.

2. Price Increases

If the mutual fund holdings increase in price but are not sold, then the fund’s shares also increase in price. At which point, the investor can sell their mutual fund shares for a profit.

3. Capital Gains

If the fund sells securities that have gone up in price, the fund has a capital gain. Typically, funds pass on these gains to investors in a distribution.

In general, the value of a mutual fund company will depend on the performance of the securities it decides to buy. Therefore, as an investor, you are purchasing a part of the portfolio’s value when you buy a mutual fund share.

4 Must-Know Things About How Mutual Funds Are Taxed

Any time an investor buys or sells a share of their mutual funds, they must report the transaction on their tax return and pay taxes on any dividends or gains. There is more to these tax issues, however. Consider the following tax information, which can not only help eliminate taxes on their mutual funds but improve the total portfolio return as well:

1. Certain funds are more tax efficient.

If you are looking to minimize taxes, it would be in your best interest to invest in mutual funds that generate no taxes or very little taxes. These funds are also referred to as tax-efficient mutual funds.

For instance, you may consider municipal bond funds that can generate income usually tax-free at the federal level. In addition, try to avoid funds that pay dividends. These funds will create more taxes than those that pay no dividends or minimal dividends.

2. How mutual fund dividends are taxed matters.

Some mutual funds that invest in stocks may receive dividends from companies they invest in and then pass these dividends to the mutual fund shareholder. In these situations, the mutual fund investor may decide to have their dividends reinvested into the fund.

They will still owe taxes even if they do not receive a check for their distributions, however, and the amount of taxes owed will depend on several factors including the holding period and the income tax bracket.

3. The best mutual funds are those with the lowest tax costs.

Many people may not realize that the best-performing mutual funds over long periods of time are those funds with the lowest tax costs. This is usually because there is a high correlation between low tax costs, low expense ratios, low turnover ratios, and high relative returns.

4. Capital gains have to be tracked.

The length of time you have owned your shares will affect how your gains will be taxed. For example, if shares were purchased and held for more than a year before the sale.

They will be considered long-term capital gains and will receive more favorable tax treatments than short-term gains. In comparison, gains from the sale of fund shares held for one year or less are considered short-term gains and taxed at ordinary income tax rates.

A tax professional can walk you through any questions you might have about mutual funds, how to set them up, and issues that arise with taxes. These experts have in-depth knowledge about every facet of the mutual funds industry, and are always happy to share their insights and experience with their clients.

Common Mistakes With Taxes on Mutual Funds

One of the biggest mistakes that investors make is placing mutual funds that generate high relative taxes within their taxable accounts. Take, for example, a bond fund and a dividend-paying stock fund that generates income that is taxable to the investor. The best way for these funds to be purchased is through a tax-deferred account, such as an IRA or annuity, which can help you avoid needless income tax.

Additionally, investors mess up by double-paying mutual fund taxes. This usually occurs when they reinvest their fund distributions into more shares. In truth, this tax problem is easy to make — especially when investors believe that the original amount invested is the basis for their tax reporting. However, the IRS states that all reinvested dividend and capital gain distributions count as investments, meaning those who do not pay close attention to this regulation could end up paying more taxes than are owed.

Get Help Determining Taxes on Mutual Funds

Mutual funds are great investment opportunities, primarily because of their simplicity. Unfortunately, everything gets messy once taxes are thrown in the mix. Some of the most common tax mistakes occur with mutual funds, and they keep happening time and time again because the investor is unclear about specific tax regulations.

Fortunately, you don’t have to go it alone. Contact Silver Tax Group today to speak with our tax professionals about any questions you may have regarding taxes on mutual funds.