By Ashlee Ogrzewalla, CFP®, CFDA®, Vice President and Manager of Financial Planning & Marketing
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Mutual funds are among investors’ most popular tools for creating a diversified portfolio. Depending on which fund you select, mutual funds can be exposed to domestic and global companies and markets.
The major benefits of mutual funds are that they can offer diversification and active management by an investment professional. The diversification that mutual funds offer may help limit big price swings or fluctuations.
Mutual funds may offer less upside than a single stock but may also have a lower downside because the exposure is split among multiple stocks. Like stocks, mutual funds pay dividends. However, unlike stocks, they may also distribute capital gains, making them less desirable to hold in a taxable account.
Capital gains distributions happen when the fund sells securities throughout the year. The fund will make a distribution if there are more gains than losses. Capital gains distributions are usually made just once, around the end of the year. In some cases, funds could be down in performance but still distribute capital gains, and the taxpayer has no control. These distributions are considered a return of principal and will reduce your cost basis in the mutual fund. Your basis can never be adjusted below zero.
Distributions are split into short-term and long-term gains. Short-term gains are generated from securities the fund held for less than one year, while long-term gains come from securities held by the fund for longer than one year. Long-term capital gains are taxed at the long-term capital gains rate, which can range from 0% to 20%, depending on the shareholder’s tax bracket. Short-term capital gains are taxable at the shareholder’s ordinary income tax rate, ranging from 10% to 37%. Per the IRS, the net capital gain distributed is taxed as a long-term capital gain to the shareholder regardless of how long the investor held the mutual fund shares.
Ordinary dividends apply to income received from stocks, mutual funds, index funds and exchange-traded funds (ETFs). They are reported on the 1099-DIV, Dividends and Distributions. This income includes dividends, interest income and net short-term gains the fund realized during the year.
An ETF is a passively managed security like a mutual fund. It is a group of stocks or bonds packaged as one security. ETFs trade like stocks. Like some stocks and mutual funds, ETFs can pay dividends. These dividends are classified as qualified or ordinary. ETFs are more tax-friendly than mutual funds because they don’t distribute capital gains, making them a popular alternative.
The tax structure of different investment types can make investment selection challenging. It’s a good practice to check in with your advisor to understand how types of investments are taxed and which account type is most suitable for investments you are considering adding to your portfolio.
Source: www.irs.gov
IMPORTANT DISCLOSURES: The information provided is based on internal and external sources that are considered reliable; however, the accuracy of this information is not guaranteed. This piece is intended to provide accurate information regarding the subject matter discussed. It is made available with the understanding that Benjamin F. Edwards is not engaged in rendering legal, accounting or tax preparation services. Specific questions on taxes or legal matters as they relate to your individual situation should be directed to your tax or legal professional.