Many investors want to know how to pay taxes on their mutual funds in the best way. How your mutual fund is taxed depends on what kinds of investments are in its portfolio. But the amount of income tax you have to pay on each dollar of distribution depends on what kind of distribution you got, how long you held the investment, and what kind of investment it was. In certain situations, distributions are taxed at your regular income tax rate, the highest rate. In other conditions, you may be able to pay the tax rate of lower capital gains. There may be no tax on some distributions at all. Here we will talk about the basics of determining taxes on mutual funds.
Capital Gains vs Ordinary Income
The difference between the ordinary income and income from capital gains can make a big difference in how much you pay taxes. In short, capital gains are only the money you get from investments you've held for more than a year. This idea is pretty easy to understand when investing in single stocks. On the other hand, mutual funds are a bit more complicated.
Mutual funds remain investment companies that buy a wide range of securities with the money that many people put in. This group of investments is called a portfolio. How long you've owned shares in a mutual fund has nothing to do with the difference between the ordinary income and capital gains regarding distributions. Instead, it depends on how long a particular investment has been in the fund's portfolio.
Calculating Your Losses and Profits
If you sell your shares inside a mutual fund, you don't have to pay taxes on any of the money you get back because you already paid taxes when you earned it. Because of this, it's essential to know how to figure out how much of your distribution comes from gains and how much comes from investments. Before you can determine whether you made a profit or a loss from your investments, you need to know how much you originally paid for the shares that you later sold. When it comes to mutual funds, it might be difficult to find out exactly how much you spent for a given share. This is known as the "base" portion of the mutual fund.
Average Basis and Cost Basis
The Internal Revenue Service (IRS) gives taxpayers two ways to figure out how their investment income is calculated: the cost basis and the average basis. If you know how much you paid for your sold shares, you may utilize the particular share identification cost basis approach. But this method may take a long time if you have a lot of shares that you bought at different times. You can also use the "first-in, first-out" method, which uses the price of the 1st share purchased as the price of the first share sold, and so on.
You can use the average basis method if you can't remember how much you paid for each share. This lets you use the total price of all your shares same as the cost basis for each share you sell. Whenever you sell mutual funds that you've had for more than a year and a half, you'll be subject to the same taxation as ordinary income. That's all it is: consistent income.
Distributions of Dividends
Mutual funds also give dividends when their assets make money or pay interest. This is in addition to the money they give out when they sell an asset. Mutual funds are also called “pass-through” investments, It means that any money they make has to be shared with their owners. Most of the time, this happens when a fund owns dividend-paying stocks or bonds, which usually pay a set amount of interest each year. Coupons are what we call these payments.
When a company announces a dividend, they also promote the ex-dividend date and record date. On the record date, the company looks at its list of shareholders to see who will get the dividend payment. Because trading stocks takes time, any sale of shares that happens less than 3 days before the recorded date, and the name of the investor who sold the shares are still on the list of shareholders.
Conclusion
Even for the most experienced investor, figuring out how much tax you owe on income and distributions from a mutual fund can be challenging. You can find out more about these things in IRS Publication 550. But if you have more than a few shares and don't keep good records, you might want to talk to a tax expert to ensure you're reporting all your investment income correctly.
