Three Common Tax Mistakes Mutual Fund Investors Make
While it’s never pleasant to contemplate the annual scramble at tax time, there are some important steps mutual fund investors can take to minimize their tax profiles. Tax time presents special challenges for investors in actively-managed mutual funds that throw off hefty dividends and capital gains several times a year. Even if taxes are the “dues” we pay for membership in society, that doesn’t mean you should be paying more than you owe. Yet many mutual fund investors do just that every year, either because they don’t know their rights under the tax code, they keep faulty records, or both. Below, we review some of the biggest pitfalls for mutual fund investors and how to avoid them.
Double-Paying on Dividends
Capital gains taxes are assessed on the difference between the amount you paid—sometimes called your “cost basis” or just “basis”—for an investment and the amount you received when you sell it. If you made money on your purchase, then you have a capital gain and will owe taxes. (If you lost money on your investment, you have a capital loss, discussed below.)
Keeping the basic principle above in mind, it’s easy to see how you might overpay capital gains taxes if you have been routinely reinvesting your dividends over the years. This is why so many investors in mutual funds with automatic dividend reinvestment programs wind up giving Uncle Sam twice his cut when they pay capital gains taxes on that investment.
Consider the following example: Let’s say you invested $4,000 in a fund a few years ago and received $800 in dividends during the period you held it. Your basis in the fund is $4,800—not $4,000. Why? Because you paid taxes on the dividend payments when they were made, even though they went directly back into new shares of the fund instead of your bank account. If you report your initial investment as $4,000 instead of $4,800, then you will wind up overstating your capital gain or understating your capital loss. In either event, you’ll wind up paying taxes you don’t owe.
Forgetting to Apply Capital Losses to Ordinary Income
When you sell an investment that has lost money, you are entitled to book a capital loss. And while it’s never pleasant taking a loss on a poorly-performing mutual fund, those capital losses can come in extremely handy during tax time. Most investors know that they can apply an unlimited amount of capital losses to offset any capital gains they took during the year. In addition, up to $3,000 of those capital losses can be used to reduce ordinary taxable income. For taxpayers in high tax brackets—and particularly for those subject to the alternative minimum tax—that $3,000 can make a big difference.
Running Afoul of the Wash Sale Rule—And How ETFs Can Help
Savvy investors know that “harvesting losses” at the end of the year is a good tax strategy, but many investors are often surprised to discover—occasionally during an audit—that the IRS has a rule designed to prevent investors from manufacturing artificial capital losses solely for the purpose of reducing capital gains. It’s called the “wash-sale” rule.
Imagine that you hold a fund that has lost some ground during the year, but you expect it to go back up. As you look over your brokerage account statement, you decide that you could really use some capital losses to offset the gains you’ve made recently, but you hate to part with your losing fund just because it’s had a bad quarter. Could you sell the fund, book the loss, and then buy it back again?
According to the IRS, you cannot sell a security for the purposes of booking a capital loss and then immediately repurchase the same—or a substantially similar—security within 30 days. If you do, the IRS will deem the sale to be a “wash” and will disallow the capital loss.
Under the current tax code, however, replacing an actively-traded mutual fund with a similar ETF does not violate the wash-sale rule. So, for instance, if you sold Fidelity Select Medical Devices (FSMEX) at a loss, you could maintain the same kind of sector exposure by replacing it with the iShares Dow Jones U.S. Medical Devices Index Fund (IHI). While the two funds don’t overlap precisely, they are similar enough to keep your portfolio balanced while you wait out the 30-day wash-sale period.
Start Thinking About Tax Time Now
Although there are still a few more days to go before summer draws to a close, it’s not too early to start thinking about end-of-the-year tax planning. Many investors put off year-end tax planning until it’s too late to make the smart moves that can meaningfully reduce their tax bills. As always, if you have significant assets in your taxable brokerage account—more than $200,000—consult with a CPA or financial planner sooner rather than later. By one estimate, investors with large taxable accounts can lose up to 40 percent of their total returns to Uncle Sam due to poor tax planning.
