At year-end, when mutual funds owned by individuals make distributions, taxpayers frequently get unpleasant tax surprises. This might happen for a variety of causes, but one frequent reason is that the fund sells some of its assets at a profit. When this happens, the shareholders are taxed on their share of the profit whether they just recently acquired it or not.
Many mutual funds give dividends to investors on record as of a certain date at the end of each year. The fund might also distribute money derived from capital gains transactions that occurred in the fund throughout the year. This can cause a lot of difficulties:
- Taxable paybacks. If you purchase shares in a mutual fund just before a dividend is paid, part of the cost is the dividends that are returned to you. Not only will the value of your recently acquired mutual fund shares go down after the payment, but you will be responsible for paying tax on money that should have gone to you!
- Kiddie tax surprise. Many parents buy mutual funds in their children’s names to benefit from their lower tax rates. The tax on unearned income is low or non-existent if it is kept below $2,100 per child. A sudden dividend or capital gain might result in a large portion of this unearned money being taxed at a higher rate.
- The $3,000 loss strategy. If you withdraw more than $3,000 in investment losses in a single year, your overall tax is lower. With appropriate tax planning, your losses may offset high income taxes. However, these losses must be offset by capital gains before they can provide any benefit. You could inadvertently render this tax approach ineffective if you receive a large capital gain.
What to do
Here are a few suggestions to help you avoid this mutual fund tax surprise:
- Limit year-end activity. Consider this year-end surprise when making mutual fund transactions. To avoid fund purchases right before dividend payouts, consider reviewing and rebalancing your portfolios at the start of the year.
- Research your mutual funds. If you want to avoid a nasty surprise at the end of the year, do some research on your mutual funds beforehand. Check out the fund’s historical trends to see which are most likely to issue a Form 1099 DIV or B (capital gain/loss) in 2017.
- Use the knowledge to your benefit. Consider putting money into these funds if you like a fund and it produces taxable events on a regular basis. This way, the tax consequences may be incorporated into your retirement planning.
Nobody likes to find out that they owe money to the IRS at tax time. The ideal solution is to choose the options that are best for you.