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Mutual fund taxes require December attention

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Unsplash+ in collaboration with Charlie Harris

Financial gifts arrive this month for many mutual fund investors. Most funds make annual distributions in December, based on their results at the October end of their fiscal year.

The money paid to fund owners also presents the Internal Revenue Service with a present.

The distributions are taxable. The fund owner owes tax on the amounts regardless of whether the money is reinvested or paid directly to the investor.

Such distributions typically are only a small portion of a fund's returns. However, sometimes the December amounts are big enough to pose a serious tax surprise. 

Investor tax forms: Regardless of the amounts you get from you investments this month, don't ignore them at tax time.

Mutual fund and other investment firms are diligent about sending account owners the requisite 1099 form and copying the IRS.

Here are the most common investment related tax statements.

Form 1099-DIV, Dividends and Distributions, is the form most investors receive. It goes to those who own a stock or a mutual fund that pays dividends or capital gains distributions.

Form 1099-INT, Interest Income, is sent when you have a bank account, typically a checking or savings one, that pays interest. This form is sent only if the interest amount exceeds $10. However, tax is still due on that $9.99 you got from that paltry 0.02 percent interest rate.

Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, is sent by brokers to clients who sold stocks, options, commodities, or other securities during the tax year. This form serves as the taxpayer's record of a taxpayer’s gains or losses.

Unlike 1099-DIV and 1099-INT form that must be sent to taxpayers by Jan. 31 of the next tax year, the deadline for 1099-B forms is Feb. 15.

Fund, not fun, tax implications: For federal tax purposes, the word ordinary is key. Ordinary dividends are shown in box 1a of Form 1099-DIV (shown below) and are taxed at ordinary income tax rates, which could be as high as 37 percent.

1099-DIV Dividends and Distributions
See more tax forms and more about them at Tax Forms 2023.

Qualified dividends, reported in box 1b, and capital gains distributions, box 2a, are taxed at the usually lower capital gains rates. That could be 0 percent for some, 15 percent for most, and 20 percent for higher income investors.

The chart below from Fidelity Investments illustrates how each type of mutual fund income, not just dividends and capital gains distributions, is taxed.

Type of distribution

Definition

Federal income tax treatment

Long-term capital gains

Net gains from the sale of shares held for more than one year; may include some distributions received from investments held by the fund

Subject to the capital gains rates, usually lower than the ordinary income tax rates

Short-term capital gains

Net gains from the sale of shares held for one year or less

May be treated as ordinary dividends, thus taxable at ordinary income tax rates

Qualified dividends

Dividends from common stock of domestic corporations and qualifying foreign corporations

Normally taxed as long-term capital gains (subject to certain holding period and hedging restrictions)

Ordinary or non-qualified dividends

Investment income earned by the fund from interest and non-qualified dividends minus expenses; often used as a blanket term that includes all taxable income except long-term capital gains.

Taxable at ordinary income tax rates

Tax-exempt interest

Some or all interest on certain bonds, usually state or local municipal bonds, designated as tax-exempt

Not taxable for federal tax purposes; may be subject to state and/or local taxes, depending on your resident state and the type of bonds purchased

Taxable interest

Interest on fixed-income securities

Taxable at ordinary income tax rates

Federal interest

Interest on federal debt instruments

Taxable at ordinary federal income tax rates, but exempt from state income tax

Required distributions

Non-investment income required to be distributed by the fund (such as foreign currency gains that are taxed as ordinary income when distributed)

Taxed as ordinary income

Return of capital

A portion of your invested principal returned to you

Not taxable

 

Reinvested for tomorrow, but taxable today: As noted earlier, when you reinvest all your fund earnings, that money is still taxable for the tax year in which the transactions occurred.

I know, not getting the money to spend makes it seem like you really didn't make it. But the IRS begs to differ, and that's the perspective that matters.

Reinvested earnings are like any other sales and purchases, and your fund company will include them on the 1099-DIV. So you must report them and pay taxes on those reinvested gains.

You need to keep good records to avoid being taxed again on the money that you rolled back into your fund when you sell part or all of it. Those prior taxed amounts will help you adjust your asset's basis to figure your correct tax bill.

More tax considerations and moves: To get an idea of potential dividends and distributions, check out your funds' web pages. They usually also provide a timeline on when you can expect official notifications.

In addition to the 1099-DIV that should arrive in January, any distributions paid to your account will be on your funds' fourth quarter statements.

The amounts you'll get could affect your estimated tax payments, which many investors routinely pay. If it's that surprising large distribution mentioned at the start of this post, you might want to consider increasing your final fourth quarter 1040-ES payment due Jan. 16.

Yes, the IRS prefers you pay in four equal installments, but when your starting estimated amount for the year gets blown up by big amounts paid in the 12th month, a case can be made for bumping up the last amount.

If your investment payouts do tend to fluctuate throughout the year, you also might want to consider using the annualized income option of paying estimated taxes. It does require accurate record keeping and filing another form, but you end up paying a larger estimated tax amount in the earning period that you actually made more money.

You also can look into tax loss harvesting. By selling other underperforming funds or securities you own, the losses can offset some or all of your mutual fund capital gains distributions.

Of course, taxes are just factor to consider when you buy a mutual fund or any investment. You want to make sure the investment is solid, meets your risk tolerance level, and fits your overall and long-term investing goals. Taxes are important, but they should not be the primary reason for making an investment choice.

As for those choices, a good financial counsellor and tax expert can help. If you can find one person who fills both roles, great. But if you need two specialists, go that route.

Their advice and the peace of mind it provides should be worth the price of helping you find investments that fit your tax and financial needs.

You also might find these items of interest:

 

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