Tax Tips: Mutual Fund Tax Pitfalls And Strategies

Q: I have often been hammered with the taxes on my investment in mutual funds. Even though I have not taken distributions from the funds, I have had to recognize a substantial amount of taxable income. I once switched from one fund to another within the same family of funds and had to pay a lot of tax on the capital gain I did not receive. Is there any way to avoid paying tax on income I did not receive? Can you explain?

A: The good thing about equity mutual funds is that investment professionals manage them. These individuals should be well qualified to judge which stocks are the most attractive, given the investor's objectives. The bad thing about these funds, besides the fees, is that the client has virtually no control over the tax consequences.

The mutual fund, not the investor, decides which of its investments will be sold and when. If its transactions during the year result in an overall gain, the investor will receive a taxable distribution, in the form of a dividend, whether he or she likes it or not. This is because funds are required to pass out almost all of their gains every year or pay corporate income tax. When an investor receives a distribution, reinvested or not, he will owe the resulting tax bill even though his fund shares may actually have declined since he bought in.

This "unwanted" distribution issue is less of a problem with index funds and so-called tax-managed or tax-efficient funds. Index funds essentially follow a buy and hold strategy, which tend to minimize taxable distributions. Tax-managed funds also lean toward a buy and hold philosophy, and when they do sell securities for gains, they attempt to offset them by selling some losers in the same year. This approach also minimizes taxable distributions.

In contrast, funds that actively "churn" their stock portfolios in attempting, not always with success, to maximize pre-tax returns will usually generate hefty annual distributions in a rising market. The size of these payouts can be annoying enough, but is even worse when a large percentage comes from non-qualifying dividend income taxed the investor's ordinary rate. On the other hand, funds that buy and hold qualified dividend and no-dividend growth stocks will pass out distributions mainly taxed at the more favorable capital gains tax rate.

The lesson here is to research the after-tax returns various funds have been earning before choosing between competing funds. However, if the investment in mutual fund is for a tax-deferred retirement account (IRA, 401(k), Keogh, SEP, etc.), the focus should strictly be on the total return and all the stuff about the distribution taxability can be ignored.

Like investments in stock shares, mutual fund shares can be sold outright creating a taxable capital gain or loss transaction. From my experience, the following are the three biggest problem areas relating to clients not understanding the rules constituting a tax-consequence sale:

1. An investor can write checks against his mutual fund account with cash coming from liquidating part of his investment in fund shares. When he takes advantage of this service, he has made a sale requiring the calculation of gain or loss on the deal.

2. An investor switches his investment from one fund in a mutual fund family to another. Once again, this is a taxable sale. Unfortunately, you learned about this the hard way!

3. An investor sells 200 shares in a fund for a tax loss. Because he participates in the fund's dividend reinvestment program, he automatically buys 50 more shares in that same fund within 30 days before or after the loss sale. For tax purposes he made a "wash sale" of 50 shares. As a result, the tax loss on those shares is disallowed. However, he does get to add the disallowed loss to his tax basis in the 50 shares acquired via dividend reinvestment.

Barry Dolowich is a Certified Public Accountant and owner of a full-service accounting and tax practice with offices in Monterey. He can be reached at 831-372-7200. Address any questions to him at PO Box 710, Monterey 93942 or email: bdolowich@gmail.com