If you’re among the millions of Americans who invest in mutual funds, you need to be aware of the year-end issues that could affect your 2020 tax bill.
- Year-end distributions. One key fact to be aware of is that mutual funds are usually required to distribute their income annually to shareholders. If you purchase a mutual fund just before a distribution date, you will receive the distribution and be required to include it in your taxable income. Since the price of the fund shares before and after a dividend distribution reflect the amount of the dividend, you are actually paying income tax on part of your own purchase price.
- Your tax basis. Your taxable gain on sales you’ve made during the year will generally be the sales price minus your tax basis. Note that transactions such as check redemptions and exchanges are usually treated just like sales. Your tax basis is generally the purchase price plus any related transaction costs, such as sales charges and brokerage fees. Your basis also includes reinvested dividends.
The IRS allows several different ways of determining basis when you’ve bought your shares at different times and don’t sell them all at once. Mutual fund companies will often report your average cost basis, which divides the total cost of all your shares by the number of shares you own. A second option is the first-in, first-out method which assumes the shares sold were the earliest ones purchased. The specific identification method lets you choose which group of shares you’re selling. Before selling, check to see which method will provide you with the lowest tax bill.
- Where to hold your funds. Of course, if you’re holding mutual funds in a retirement account, your investment gains shouldn’t trigger any immediate tax. Just be aware that when distributions are made (other than from a Roth IRA), they’ll be taxed at ordinary income rates. If you anticipate significant appreciation, you may want to own those mutual funds outside of a retirement plan so any future gains would be eligible for the preferential capital gains rates.
- Tax planning. Please call if you have questions about minimizing the income taxes on your mutual fund investments.
As always, should you have any questions or concerns regarding your tax situation please feel free to call.