Tax Tip Tuesday: Asset Location Can Help Manage Large Mutual Fund Distributions

By Theresa Cagle Fry, Senior Vice President and Manager of IRA’s, Retirement & Education Planning

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If you own mutual funds in your taxable investment account, you may have been surprised to find capital gains reported even though you did not buy or sell any shares. Mutual funds must distribute dividends and any realized capital gains earned in the prior 12 months. These distributions are typically paid at the end of the year to shareholders of equity mutual funds.

When a fund pays distributions to shareholders, they can be treated as long-term capital gains, short-term capital gains or dividends. The long-term or short-term nature of the distribution is based on how long the fund held the investment, not how long you (the investor) held shares of the mutual fund.

You – and the IRS – will receive Form 1099-DIV if capital gain distributions were paid to you for mutual funds held in your taxable investment accounts. Short-term capital gains are distributed as ordinary dividends (Box 1a). Distributions of net investment income are included as ordinary or qualified dividends (Box 1a or 1b). Long-term capital gain distributions are included in total capital gain distributions (Box 2a).

Long-term capital gains and qualified dividends are subject to tax rates of 0%, 15%, or 20% depending on your income, and high-income earners ($200,000 for individuals; $250,000 for married taxpayers filing jointly) must add on the 3.8% net investment income tax to that rate. Short-term capital gains – which are considered ordinary dividends – and other ordinary dividends, are subject to ordinary income tax rates. Net capital losses are not distributed to shareholders. The fund carries the losses over to be used to offset future capital gains of the fund.

Capital gain distributions are an inevitable part of mutual fund investing. If you are concerned about the tax exposure due to mutual fund capital gain distributions, changing where you hold mutual fund investments may help. Asset location is a strategy used to increase the tax efficiency of your investment portfolio. By investing in a tax-deferred retirement account, you won’t owe taxes on any mutual fund capital gain distributions or dividends when paid to you. Instead, you will pay income tax on any distributions you take from the retirement account, which is typically during your retirement years. Changing the location of where you hold mutual funds from taxable accounts to IRAs, 401(k)s or other types of retirement accounts; it can change both the nature and the timing of the taxes that are paid.

While taxes play an important role in making investment decisions, your goals and objectives should take priority. Finding the right balance for your particular situation can be tricky. Contact a financial advisor today if you would like to review your investments or discuss a more tax efficient approach to investing.

 

Benjamin F. Edwards does not provide legal or tax advice, therefore it is also important to consult with your legal and tax professionals for additional guidance tailored to your specific situation.