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Mutual Funds Not Always Tax Friendly

Stock Market News

July 1999

Mutual Funds Not Always Tax Friendly

Learn what savvy investors know about tax loopholes for mutual funds. Taxes you pay can greatly affect your gains, however, a little knowledge can mean big savings.

Hold funds that are not tax efficient in
your IRA, 401(k) plan, or other tax-deferred
retirement plan.

Funds that are not tax efficient have high turnover rates and distribute large amounts of short-term capital gains to shareholders each year. These distributions are taxable unless the fund is held in a tax-deferred account. Then income earned by the fund builds up and compounds tax free until you begin making withdrawals.

Maximize fund profits by carefully tracking any dividends that you reinvest in the fund.

Keep a file for every fund that you hold and keep copies of the annual and quarterly statements you receive in this file. Review and watch these dividends you reinvest in the fund because you must pay tax each year on any dividends from your fund. You pay even if you receive no cash from the fund because you automatically reinvest the dividends in additional fund shares. Watch and keep track or you will pay tax on the dividends twice; when dividends are paid and again when you sell those shares.

Add reinvested dividends and capital gains distributions to your tax cost (basis) in your fund shares because capital gains taxes are owed on the difference between the selling price and your tax cost. Increasing the tax cost reduces your tax bill.

Increase the yield earned from municipal bond investments by buying funds that own private purpose munis.

Interest paid by private purpose municipal bonds is free from regular tax but subject to the Alternative Minimum Tax (AMT). To compensate, they pay higher yields than regular municipal bonds. Investors who do not owe the AMT can earn more from their mutual bond portfolio.

Read the fund's prospectus before you invest in tax-free minicipal bond or money markets to find out how much of the portfolio is invested in private purpose municipal bonds.

Buy mutual funds all year EXCEPT in November
and December

Funds may distribute any capital gains during the year, and they must distribute any dividends received from the stocks and bonds in their portfolio. When you purchase shares in a fund that will soon pay dividends, you are paying tax on the money you invested, since you paid more for the shares due to that as-yet unpaid dividend. If you purchase 100 shares from ABC Fund for $2000 at $20 per share on December 1, the fund pays a $2 per share dividend on December 15, and the fund's price drops to $18. You now own $1,800 of shares plus $200 cash but you owe tax on the dividend of $79.80 (39.6% of $200). In those two weeks, your $2,000 investment has been reduced to $1,920.80.

Before you buy shares, analyzing a fund's
capital gains exposure saves you taxes.

Funds must distribute their dividends and interest to their shareholders every year while nothing prevents funds from building up long-term gains in their portfolios. This means two funds that look identical can produce very different aftertax returns when they sell the shares that they own.

Due to appreciation, a fund's value may include as much as 50% of capital gains appreciation. If the fund manager sold $1 million of shares, shareholders would recieve their proportionate share of $500,000 in longterm capital gains. A different fund's value might only comprise 10% of capital gains. Here the tax would be lower. Look for the capital gains exposure in anaylses prepared by data providers such as Morningstar Inc. or call the fund.

Time your fund purchases so you can deduct
your losses.

Under the "wash sale" rule, you can't deduct a loss when you sell shares in a fund and have bought shares in the same fund 30 days before or 30 days after the orginal sale. Your loss will be deferred until the second batch of shares is sold. Investors who have elected to reinvest dividends automatically and who sell only part of their holdings will continue to "buy" shares by way of reinvested dividends after the sale. They have to remember to defer the amount of loss equal to the reinvested dividends.

Minimize your taxes by choosing the most
favorable method of calculating your gains.

The FIFO (first-in, first-out) method is a requirement of the IRS to figure your gain on mutual fund sales, unless you elect an alternative method. FIFO assumes that the shares you sold were the first ones you bought, usually the ones with the lowest cost and the highest built-in gains.

A better method: The specific identification method can be used to identify the shares you are selling, letting you pick which ones to sell and control the amount of tax you pay. Detailed record keeping when you purchase fund shares, including the purchase date, amount you paid, price per share, and the number of shares is crucial so you can sell the shares that will produce the lowest taxable gain. When you sell them, disignate in writing which shares are to be sold by the date of the purchase.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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