How to avoid double-paying your mutual fund
by Ric Edelman 80
all the advantages offered by mutual funds, taxation is certainly
not one of them. In fact, its 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. Youll
receive a dividend distribution, which is taxable as all dividends
are taxed, and youll 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, its 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 havent sold any shares
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. Ill
bet this is true even for those who automatically reinvest their
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.
Heres how it happens: Lets 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 (Im ignoring compounding to keep this
example simple), and hed 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 theyve 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 (its 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 Caseys accountant asked how much Casey
invested, Caseys answer should have been $14,000not
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, dont answer. Instead, give your tax preparer
the statements you collected.
Caseys reply should have been, How much did I invest?
I dont know. Thats what I hired you for! Heretake
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 cant sell part of a housebut
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 sellthe 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 purchasedmeaning
their profit is the highest. So maybe it makes sense to sell the
newest shares firsteven though their sale is considered short
term. Still, depending on whats 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 dont 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.
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.