How to avoid double-paying your mutual fund taxes

by Ric Edelman ’80

or all the advantages offered by mutual funds, taxation is certainly not one of them. In fact, it’s the biggest headache associated with owning them. Mutual funds are not investments, but rather pools of money that buy investments. Say you own a stock fund and the fund manager buys a stock. Further say the stock pays a dividend and grows in value, and the fund manager then sells the stock. You’ll receive a dividend distribution, which is taxable as all dividends are taxed, and you’ll also receive a capital gains distribution, taxable at capital gains rates.

Thus, even if you might have owned the fund for just a month or two, and even though you have not yet sold the shares of your fund that you originally bought, it’s quite possible that you could receive a long-term capital gain distribution. This would occur because the fund sold an asset that it had held for the requisite period of time (more than 12 months), even though you have only held the fund for a short period and haven’t sold any shares yet.

Are you overpaying taxes on your mutual funds?

All this leads to a surprisingly common mistake among mutual fund investors: They pay taxes twice on their mutual fund profits. I’ll bet this is true even for those who automatically reinvest their distributions.

The IRS contends that when your fund declares a dividend or capital gain, it is your choice to reinvest this distribution or not. Since most investors choose to reinvest, millions of mutual-fund investors overpay the taxes due on their mutual funds.

Here’s how it happens: Let’s say Casey invests $10,000 into a bond fund that pays an 8% annual dividend, or $800. Casey automatically reinvests this $800 and the fund gives him more shares. At tax time, Casey must pay taxes on the $800 he earned that year.

If Casey were to do this for five years, he would earn a total of $4,000 in dividends (I’m ignoring compounding to keep this example simple), and he’d pay taxes each year along the way. At the end of the five years, his fund would be worth $14,000 (his original investment of $10,000 plus the $4,000 in dividend reinvestments). Thus, if Casey were to sell his fund, he would receive a check for $14,000. Therefore, he would owe nothing in taxes because he had already paid them.

But many fund investors blow it. They forget they’ve paid taxes each year on the dividends; when they sell their fund and get their check for $14,000, they also get from the fund an IRS Form 1099 stating that amount (it’s called gross proceeds). They dutifully give the 1099 to their tax preparer who asks, in an effort to determine the profit they earned (and thus the tax owed), “How much did you invest in this, anyway?”

And they say, “Ten grand,” and the tax preparer records that they made a profit of $4,000, includes it on their Schedule D, and they end up paying taxes on that profit all over again! This sounds preposterous, but I can assure you it is perhaps the most common tax mistake made by mutual fund investors.

Do you see the trap? Most investors think the “amount invested” is the amount of money they sent to the fund. But the IRS says all reinvested dividend and capital gain distributions count as “investments,” too. Therefore, when Casey’s accountant asked how much Casey invested, Casey’s answer should have been $14,000—not $10,000!

You can avoid this problem simply by following these steps: keep all your mutual-fund statements, and when your tax preparer asks you a question, don’t answer. Instead, give your tax preparer the statements you collected.

Casey’s reply should have been, “How much did I invest? I don’t know. That’s what I hired you for! Here—take my statements and figure it out yourself!” If you prepare your own taxes, be aware of this trap.

What to do if you sell only part of an investment

You certainly can’t sell “part” of a house—but you can sell part of other investments. Say that over a period of 10 years, you accumulate 1,000 shares of a mutual fund that are now worth $25 per share, for a total of $25,000. Also say you need five grand for a down payment on a car, so you sell 200 shares. Which shares did you sell—the ones you bought 10 years ago, the ones you acquired most recently, or those in between?

Your answer could make a big difference come tax time. Your first reaction might be to sell the oldest shares, so that the sale is treated as a long-term gain, and subject to the lowest capital gains rate. But the oldest shares are probably the cheapest that you purchased—meaning their profit is the highest. So maybe it makes sense to sell the newest shares first—even though their sale is considered short term. Still, depending on what’s happened in the market lately, some of the middle shares might be the best candidates for sale.

Clearly, the shares you sell will determine your tax liability. The problem is that most investors don’t know that they have a choice. And, actually, you have four choices (see below). But make your selection carefully, for once you pick a method, you cannot change it for that particular investment.

Four ways to sell investments

The FIFO method

First In-First Out assumes you first sell the shares you bought first. (The first person who gets on the bus is the first person to get off the bus.) This is the default method; the IRS (as well as your broker or mutual fund company) assumes you use this method unless you notify them otherwise.

The specific identification method

You name which shares you are selling (you do this by referring to the date you acquired the shares to be sold). For this method to be successful, you must specify to the mutual fund company or to the advisor of record serving your account the particular shares to be sold, and you must do this at the time of sale. Furthermore, you must receive confirmation of your specification from your advisor in writing within a reasonable time, and the confirmation by the mutual-fund company must confirm that you instructed your advisor to sell particular shares.

The average cost single method (only available for mutual funds)

Figure the tax on the average cost and the average profit from all your trade lots.

The average cost double method (only available for mutual funds)

Separate the trade lots into two groups: those held one year or less and those held more than one year, and then figure the tax on the average of each group.

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Ric Edelman CFS, RFC, CMFC, CRC is chairman of Edelman Financial Services Inc. and best-selling author of The New Rules of Money, The Truth about Money and Ordinary People, Extra-ordinary Wealth. He hosts two award-winning radio and television shows, publishes his own newsletter, is a syndicated columnist and a highly acclaimed speaker. He can be reached by e-mail or by phone at 703-818-0800.