Avoid The Mutual Funds Dividends Tax Ambush

Mutual funds that provide for capital gain and dividend earnings may have a surprise for you. Don't be caught off guard!

The dividends and capital gains earned by mutual funds are taxed to fund investors each year, even though you reinvest all of your earnings back into the fund!

Dividends received by mutual funds from stocks it owns are taxed to fund investors at ordinary income tax rates ranging from 15 to 39.6 percent. Capital gain distributions, which represent the net gains from the stocks sold during the year, can be either short-term or long-term capital gains. Short-term gains are taxed at the individual fund investors ordinary income tax rates and represent the net fund gains on all stocks actually sold by the fund that were held less than one year. Long-term gains are taxed at long-term capital gain tax rates of 20 percent for most individuals and 10 percent for individuals in the 15 percent income tax bracket.

Capital gains distribution can vary a great deal between funds. Mutual funds with a lot of portfolio turnover can generate a lot more capital gain tax to fund investors than mutual funds that have longer term holding positions of their individual stocks.

What can you do to provide yourself with the most efficient after-tax return?

1. If you are a long-term, "buy and hold" mutual fund investor, you can find the before-tax and after-tax returns for thousands of funds at http://www.morningstar.com. (Morningstar is a subscription service, which costs $9.95 per month.)

2. Compare the mutual fund's average holding periods of its stock investments to other funds in the same category. The longer the average holding period, the better your chances are that the fund will create less capital gains taxes on a year to year basis.

With a little bit of work and weighing your options, you can avoid a nasty tax ambush. And, if you would like a little back up at any time, we are always here to help.

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