Chapter 18
The Taxing Side of Mutual Funds
In This Chapter
Checking out Form 1099-DIV and distributions from mutual funds
Understanding the issues of selling funds
Browsing Form 1099-R and retirement fund withdrawals
You invest in mutual funds to make money. But guess who starts licking his chops when he hears about money being made? That’s right: good ol’ Uncle Sam. And state governments, too. (In Chapter 17, I explain the different ways that mutual funds can make you money: either through distributions (capital gains and dividends) or through appreciation. If the fund that made the money is being held outside a tax-sheltered retirement account, federal and state governments will demand a portion of your fund’s distributions and of your profits when you sell shares in a fund for more than you paid for them.)
Once each year, the mutual fund companies or brokerage firms where you’re holding funds send you one or more tax forms that tell you how much taxable money you made on your mutual funds held outside of retirement accounts. (Remember, you don’t need to file anything with funds held inside retirement accounts.) Come April (or whenever you get around to completing your tax returns), you must transfer the information on these fund-provided tax forms to your income tax return, where you calculate how much tax you actually owe on the money you made from your mutual funds.
If you cringed when you read the words tax forms, you’ve obviously battled these ugly beasts. I sometimes wonder if the people who write tax forms come from another planet — that would perhaps explain their use of what appears to be a nonhuman form of communication. But don’t despair. I devote this entire chapter to helping you interpret the hieroglyphics on these sometimes intimidating documents.
Just for toughing out this chapter, you get a few rewards. I show you how to use a fund’s tax forms to help you discover whether your mutual fund money is being invested in the most tax-friendly way. I also give you some tips on reducing your tax bill if you have to sell some mutual funds.
Mutual Fund Distributions Form: 1099-DIV
If you’re an employee of a company, you’re probably familiar with IRS Form W-2, that little piece of paper that comes in late January or early February and sums up the amount of money your employer paid you over the previous year. You’re required to report this income on your income tax return.
Form 1099-DIV is similar to a W-2, but instead of reporting income from an employer, it reports income from mutual funds that you hold outside of retirement accounts. By income, I mean capital gains and dividend distributions, which I explain in Chapter 17.
Like the W-2, Form 1099-DIV should arrive in your mailbox in late January or early February. You should get one for every nonretirement account you held money in during the tax year. Call the responsible company if you don’t get one for an account that you think you should. (And if you’re tired of receiving these forms from so many fund companies, visit Chapter 9, where I explain the paperwork-friendly benefits of consolidating your mutual fund holdings into a discount brokerage account.)
Also like the W-2, a copy of each of your 1099-DIVs is sent to the IRS and your state authorities, so don’t get any ideas about fudging the information on your tax return.
Figure 18-1 is a sample Form 1099-DIV, which I use to walk you through the form. First, notice that the distributions are divided into various boxes. (Actually, most mutual fund companies display this information in columns, but they’re still called boxes.) This division is done because different parts of your distributions are taxed at different rates, and the IRS wants to know what is what.
Jump in to these boxes and see what you find. In the following sections, I discuss the boxes that pertain to mutual funds.
Figure 18-1: Form 1099-DIV reports dividends and capital gains your funds paid.
Box 1a: Total ordinary dividends
All types of mutual funds pay dividends, which account for all of a money market’s return, most of a bond fund’s return, and part of a stock fund’s return. Thanks to tax laws passed in 2003, dividends paid by stocks are taxed at the same reduced tax rate that applies to long-term capital gains, which I discuss in just a bit. Stock dividends are termed qualified dividends and reported in Box 1b (discussed in the next section). Thus, Box 1a only includes dividends from taxable money market and bonds that are held by mutual funds.
Untrue to its name, however, ordinary dividends also include short-term capital gains distributions — profits from securities that the mutual fund bought and sold within a year. These short-term capital gains are lumped together with your dividend income because they’re both taxed at your ordinary income tax rate.
The distributions reported as ordinary dividends are taxed at your highest possible rate: up to 35 percent on your federal income tax return depending on your annual income. If you’re in a higher tax bracket, you don’t want to see big ordinary dividends. You’d be better off with investments that don’t produce so much taxable income. (Chapters 11 and 12 explain how to select tax-friendly money market and bond funds.) For stock mutual funds, if you’re seeing big ordinary dividends, your fund must be making a lot of short-term trades. Outside of retirement accounts, regardless of your tax bracket, you have no reason to own mutual funds that generate a lot of short-term capital gains. Chapter 13 gives recommendations for tax-friendly stock funds.
Box 1b: Qualified dividends
Qualified dividends include dividends paid by corporations to their stockholders (stock dividends). If you’re in the 10 or 15 percent federal income tax bracket, qualified (stock) dividends are tax-free — a 0 percent tax rate! For those in the higher federal tax brackets, the qualified dividend tax rate is 15 percent.
Box 2a: Total capital gains distributions
Because short-term capital gains are reported in Box 1a, this box would be more appropriately called “Long-term capital gains distributions,” which are profits from securities sold more than 12 months after their purchase. Long-term capital gains are taxed at a lower rate than regular income, taxable money market and bond dividends, and short-term capital gains. The federal tax rate on long-term gains is 15 percent for those in an ordinary tax bracket of 25 percent or higher and long-term capital gains are tax-free for those in the 10 or 15 percent ordinary tax brackets.
You can count the lower tax rate on long-term capital gains as one more benefit of the buy-and-hold investing strategy (see Chapter 10). Not only does this strategy typically generate higher returns than short-term trading, but also for investments held outside of retirement accounts, it’s gentler on your tax bill. The tax relief and the potential for higher returns are why mutual funds that tend to buy and hold their securities are preferable for nonretirement accounts.
Box 3: Nondividend distributions
You rarely see numbers in the nondividend distributions section of Form 1099-DIV. This box is where funds report if they made distributions during the year that repaid a shareholder’s original investment. Like the principal returned to you if a bond or CD you’ve invested in matures, this chunk of money isn’t taxable.
For shares held outside of retirement accounts, these nondividend distributions factor into your computation of the gain or loss when the shares are sold. For purposes of calculating any gain, if and when you sell these shares, you must subtract nondividend distributions from the amount you originally paid for these shares.
Box 4: Federal income tax withheld
If your funds report that federal income tax was withheld, that can be bad news. It means that you’re being subjected to the dreaded backup withholding. If you don’t report all your mutual fund dividend income (or don’t furnish the fund company with your Social Security number), your future mutual fund dividend income is subject to backup withholding of 28 percent! To add insult to injury, in the not-too-distant future, you’ll receive a nasty notice from the IRS listing the dividends you didn’t report. You end up owing interest and penalties.
Find out right away what’s going on here. Either you or the IRS could’ve made a mistake. Perhaps you didn’t provide a correct Social Security number or you’ve been negligent in reporting your previously earned taxable income to the IRS. Fix this problem as soon as you can. Call the IRS at (800) 829-1040.
Don’t despair about the tax that your fund withheld. The withholding wasn’t for nothing — you’ll receive credit for it when you complete your Form 1040 on the line “Federal income tax withheld.”
Box 6: Foreign tax paid
If you invest in an international mutual fund, the fund may end up paying foreign taxes on some of its dividends. The foreign taxes paid by the fund are listed on Form 1099-DIV because the IRS allows you two ways to get some of this money back. You can choose one of the following:
Deduct the foreign tax you paid on Schedule A (the “Other taxes” line), as long as you have enough deductions to itemize on Schedule A.
Claim a credit on Form 1040 (“Foreign tax credit” line).
Because a credit is a dollar-for-dollar reduction in the tax that you owe, the latter move may save you more taxes — but it may also be more of a headache because you may need to complete another IRS form, Form 1116, which is a doozy. However, if the total foreign taxes you pay are $300 or less ($600 or less for a married couple filing jointly), you can claim the credit directly on Form 1040 without having to fill out Form 1116.
When You Sell Your Mutual Fund Shares
Besides distributions, the other way to make money with a mutual fund is through appreciation. If the price of your shares moves higher than the price at which you bought them, your investment has appreciated. Your profit is the difference between the amount you paid for the investment and the amount the investment is currently worth. For investments held outside of retirement accounts, that profit is taxable.
However, you don’t actually owe any tax on the appreciation until you sell the shares and lock up your profit. Then you must report that profit on that year’s tax return and pay capital gains tax on it. Conversely, when you sell a fund investment at a loss, it’s generally tax deductible. You should understand the tax consequences of selling your fund shares and always factor taxes into your selling decisions.
What’s confusing to some people about this talk of capital gains and losses is that each year your fund(s) may have been paying you capital gains distributions (see the preceding section) which you also owed tax on. So you may rightfully be thinking, “Hey! I’m being taxed twice!”
It’s true that you’re being taxed twice but not on the same profits. You see, the profits the fund distributed, which resulted from the fund manager selling securities in his fund at a profit, are different from those profits that you realize by selling your shares.
You have no control over fund distributions. They happen at regular intervals — at least once a year — whether you like it or not, and you must pay taxes on them when they occur from nonretirement account holdings. Taxes on fund appreciation, on the other hand, can be indefinitely delayed if you choose. As long as you hold the investment and don’t sell it, the federal and state governments can’t get their hands on the profit — one more advantage of buy-and-hold investing. In fact, if you hold an appreciated asset outside of retirement accounts, that asset can be transferred at your death to your heirs, and the capital gain is eliminated for tax purposes. Of course, the other way to avoid taxes on mutual fund profits is to hold them inside retirement accounts; then you don’t owe taxes at all (until, of course, you start taking retirement withdrawals).
Introducing the “basis” basics
Suppose that you sell a mutual fund. In order to compute the taxable capital gain or the deductible capital loss, you have to compute your fund’s tax basis. Basis is the tax system’s way of measuring the amount you originally paid for your investment(s) in a mutual fund. I say investments (plural) because you may not have made all your purchases in a fund at once; you may have reinvested your dividends or capital gains into buying more shares or simply bought shares at different times by sending the fund company additional money. For example, if you purchase 100 shares of the It’s Gotta Rise mutual fund at $20 per share, your cost basis is $2,000, or $20 per share. Simple enough.
But now suppose that this fund pays a dividend of $1 per share (so that you get $100 in dividends for your 100 shares) and suppose further that you choose to reinvest this dividend into purchasing more shares of the mutual fund. The price of shares has gone up to $25 per share since your original purchase, so the reinvested $100 buys you four new shares. You now own 104 shares, which, at $25 per share, are worth $2,600.
But what’s your basis now? Your basis is your original investment ($2,000) plus subsequent investments ($100) for a total of $2,100. Thus, if you sold all your shares at $25 per share, you’d have a taxable profit of $500 (current value of $2,600 less $2,100 — the total amount invested or basis).
For recordkeeping purposes, save your statements detailing the purchases in your accounts. Most mutual fund companies provide year-end summary statements that show all transactions throughout the year. Thanks to their computer systems, fund companies also should be able to tell you your average cost per share when you need to sell your shares. As I discuss in the following sections, using the average cost method isn’t necessarily the optimal method to minimize your taxes.
Accounting for your basis
If you understand the concept of basis for your fund investments (see the preceding section), you can put that understanding to work. Here I introduce you to the different ways that taxpayers commonly use (and that the IRS approves) to calculate a basis when selling nonretirement account mutual fund investments.
If you sell all your shares of a particular mutual fund that you hold outside a retirement account at once, you can ignore this issue. (After reading through the accounting options that the IRS offers, you’ll probably feel that you have more incentive to sell all your shares in a fund at once!)
Be aware that after you elect one of the following tax accounting methods for selling shares in a particular fund, you can’t change to another method for the sale of the remaining shares. Regardless of the method you choose, your mutual fund capital gains and capital losses are recorded on Schedule D of IRS Form 1040.
Regardless of which tax cost accounting method you choose for your fund sales, be careful not to overpay your capital gains tax when completing your annual tax return. Remember that the maximum tax rate for long-term capital gains (investments held more than 12 months) is 15 percent (tax-free if you’re in the 10 or 15 percent federal tax bracket). Be sure to complete all the relevant portions of IRS Form 1040 Schedule D.
Specific identification method
The first fund basis option that the IRS allows you to use when you sell a portion of the shares of a fund is the specific identification method. Here’s how it works. Suppose that you own 200 shares of Global Interactive Couch Potato fund (you laugh — but there really was a fund with a name similar to this!), and you want to sell 100 shares. Suppose further that you bought 100 of these shares ten years ago at $10 per share and then another 100 shares two years ago for $40 per share. (To keep this example simple, I’m assuming that you didn’t make any other purchases from reinvestment of capital gains or dividends.) Today, the fund is worth $50 per share. (Being a couch potato has its rewards!)
Which 100 shares should you sell? The IRS gives you a choice. You can identify the specific shares that you sell. With your Global Interactive Couch Potato shares, you may opt to sell the last or most recent 100 shares you bought — or some combination of shares from each purchase that totals 100. (Selling the most recent shares will minimize your tax bill because you purchased these shares at a higher price.) If you sell this way, you must identify the specific shares you want the fund company (or broker holding the shares) to sell. To identify the 100 shares to be sold, use either or both of the following ways:
Original date of purchase
Cost when you bought the shares
You may wonder how the IRS knows whether you specified shares before you sold them. Get this: The IRS doesn’t know. But if you’re audited, the IRS will ask for proof that you identified the shares to be sold before you sold them. It’s best to put your sales request to the fund company in writing and keep a copy for your tax files.
Although you can save taxes today if you specify selling the shares that you bought later at a higher price, don’t forget (the IRS won’t let you) that when you finally sell the other shares, you owe taxes on the larger profit. The longer you expect to hold these other shares, the greater your chances of earning more money when you sell (and thus owing more in taxes). Of course, you always run the risk that Congress raises tax rates in the future or that your particular tax rate rises.
The “first-in-first-out” method
Another method of accounting for which shares are sold is the method the IRS forces you to use if you don’t specify before the sale which shares you want to sell: the first-in-first-out (FIFO) method. FIFO means that the first shares you sell are simply the first shares that you bought. Not surprisingly, because most stock funds appreciate over time, the FIFO method leads to paying more taxes sooner. In the case of the Global Interactive Couch Potato fund, FIFO considers that the 100 shares sold are the 100 that you bought ten years ago at the bargain-basement price of $10 per share.
The average cost method
Had enough of fund accounting? Well, unfortunately, we’re not done yet. The IRS, believe it or not, allows you yet another fund accounting method: the average cost method. If you bought shares in chunks over time and/or reinvested the fund distributions (such as from dividends) into more shares of the fund, then tracking and figuring which shares you’re selling could be a real headache. So the IRS allows you to take an average cost for all the shares you bought over time.
If you sell all your shares of a fund at once, you use the average cost basis method. You may also prefer this method when you sell a portion of a fund that you hold. Because many fund companies calculate this number for you, you can save time and possible fees paid to a tax preparer to crunch the numbers.
Deciding when to take your tax lumps or deductions
If funds held outside of retirement accounts increase in value, you won’t want to sell them because of the tax bite. If, on the other hand, they decline in value, you may not know whether to sell them and, thus, lock in your losses. So how do you decide what to do and what role taxes should play in your decisions? As I discuss in Chapter 17, several issues can factor into your decision to sell a fund or hold on to it. Taxes are an important consideration. So, what do you need to know about them?
Cashing in long-term gains and keeping taxes low
You do need to realize that taxes are important, but don’t let them keep you from doing something you really want to do. Suppose, for example, that you need money to buy a home or take a long-postponed vacation — and selling some mutual funds is your only source of money for this purpose. I say go for it. Even if you have to pay state as well as federal taxes totaling, say, 20 percent of the profit, you’ll have a lot left over. Before you sell, however, do some rough figuring to make sure that you have enough money to accomplish your goal. Remember, you pay far lower tax rates when selling at a profit if you’ve held the fund for more than one year.
If you hold a number of funds, give preference to selling your largest holdings (that is, the ones with the largest total market value) with the smallest capital gains. If you have some funds that have profits and some with losses, you can sell some of each, subject to IRS rules, in order to offset the profits with the losses.
Selling for tax deductions and the famous wash sale rule
Some tax advisers advocate doing year-end tax-loss selling. The logic goes something like this: If you hold a mutual fund that has declined in value and you hold that fund outside a retirement account, you should sell it, take the tax write-off, and then buy the fund (or something similar) back. (In fact, you can employ this strategy at any point during the year, not just at year’s end.)
I don’t think that selling solely for taking a tax loss is worth the trouble, particularly if you plan on holding the repurchased shares for a long time. Remember that by selling and buying back the shares, you’ve lowered your basis, which increases the taxable profit after you sell the repurchased shares (assuming, of course, that they appreciate). To find out about your basis, see the section “Introducing the ‘basis’ basics,” earlier in this chapter.
Plus, if you sell a fund for a tax loss and buy back shares in that same fund within 30 days of the sale, you can’t deduct the loss because you violated the wash sale rule. The IRS won’t allow deduction of a loss for a fund sale if you buy that same fund back within 30 days. As long as you wait 31 or more days, you won’t violate the wash sale rule. If you’re selling a mutual fund and want to reinvest that money soon, you can easily sidestep this rule simply by purchasing a fund similar to the one you’re selling.
Try not to have net losses (losses plus gains) that exceed $3,000 in one year. You can’t claim more than $3,000 in net short-term or long-term losses in any one year. If you sell funds with net losses that total more than $3,000 in a year, you must carry the excess losses over to future tax years. This situation not only creates more tax paperwork, but also it delays taking the tax deduction.
Looking at fund sales reports: Form 1099-B
When you sell shares in a mutual fund, you receive Form 1099-B early in the following year. This document is fairly useless because it doesn’t calculate the cost basis of the shares that you sold. Its primary value to you is that it nicely summarizes all the transactions that you need to account for on your annual tax return. This form, which is also sent to the IRS, serves to notify the tax authorities of which investments you sold so that they can check your tax return to see if you report the transaction.
If some of the sales listed on your Form 1099-B are from check-writing redemptions, stop writing checks on those funds! Keep enough stashed in a money market fund and write checks only from that type of account. Money market fund sales aren’t tax reportable because a money fund’s share price doesn’t change. Thus, you get fewer tax headaches!
Getting help: When you don’t know how much you paid for a fund
When you sell a mutual fund that you’ve owned for a long time (or that someone gave you), you may have no idea of its original cost (also known as its cost basis).
If you can’t find that original statement, start by calling the firm where you bought the investment. Whether it’s a mutual fund company or brokerage firm, it should be able to send you copies of old account statements. You may have to pay a small fee for this service. Also, increasing numbers of investment firms (particularly mutual fund companies) automatically calculate and report cost-basis information on investments that you sell. Generally, the cost basis they calculate is the average cost for the shares that you purchased.
For a small fee, the research firm of Prudential American Securities may be able to help you figure out how much you originally paid for your funds. Contact the firm at (626) 795-5831 or online at www.securities-pricing.com.
Retirement Fund Withdrawals and Form 1099-R
Someday, hopefully not before you retire, you’ll need or want to start enjoying all the money that you’ve socked away into great mutual funds inside your tax-sheltered retirement accounts. The following sections explain what you need to know and consider before taking money out of your mutual fund retirement accounts.
Minimizing taxes and avoiding penalties
Although many different types of retirement accounts exist (IRAs, SEP-IRAs, Keoghs, 401(k)s, 403(b)s, and so on), as well as many tax laws governing each, the IRS has declared one rule that makes understanding taxes on withdrawals a little easier. All retirement accounts allow you to begin withdrawing money, without penalty, after age 591//2. (Why they didn’t use a round number like 60 is beyond me.)
If you withdraw money from your retirement accounts prior to age 591//2, in addition to paying current income tax on the distribution, you also must pay penalties — 10 percent of the amount of the taxable distribution at the federal level and whatever penalties your state charges. (You compute the penalty on Form 5329 — “Additional Taxes on Qualified Plans [Including IRAs] and Other Tax-Favored Accounts.”)
Exceptions to the early withdrawal penalty do exist: You’re allowed to make penalty-free withdrawals before the age of 591//2 if any of the following conditions apply:
You’ve stopped working after you reach age 55 (whether by retirement or termination).
The withdrawal was mandated by a qualified domestic relations court order.
You have deductible medical expenses in excess of 7.5 percent of your adjusted gross income.
Early retirement account distributions are also exempted from a penalty if they’re paid because of death or disability, paid over your life expectancy, or rolled over to an IRA. Withdrawing money from an IRA for a first-time home purchase (up to $10,000) or higher education expenses is also permitted.
Of course, you pay current income taxes, both federal and state, when you withdraw money that hasn’t previously been taxed from retirement accounts. The one exception is for withdrawing money early from the new Roth IRA accounts for a home purchase — in this case, you don’t owe any income tax on the withdrawn investment earnings as long as you meet eligibility requirements.
Making sense of Form 1099-R for IRAs
If you receive a distribution from your mutual fund IRA, the mutual fund company or brokerage firm where you hold your funds will report the distribution on Form 1099-R (see Figure 18-2). These distributions are taxable unless you made nondeductible contributions to the IRA (a situation I cover momentarily).
Figure 18-2: Here’s where funds report your retirement plan distributions.
Here’s a rundown of the relevant boxes on your 1099-R:
Box 1, Gross distribution: The amount of money that you withdrew from your IRA. Make sure that this figure is correct: Check to see if it matches the amount withdrawn on your IRA account statement. This amount is fully taxable if you’ve never made a nondeductible contribution to an IRA — that’s an IRA contribution in which you didn’t take a tax deduction and, therefore, filed Form 8606 (“Nondeductible IRA Contributions, Distributions and Basis”).
Box 2a, Taxable amount: The taxable amount of the IRA distribution. However, the payer of an IRA distribution doesn’t have enough information to compute whether your entire IRA distribution is completely taxable or not. Therefore, if you simply enter this amount on your tax return as being fully taxable, you’ll overpay on your taxes if you’ve made nondeductible contributions to your IRA. If you made nondeductible contributions, compute the nontaxable portion of your distribution on Form 8606, which you need to attach to your annual tax return.
Withdrawing from non-IRA accounts
Retirement account withdrawals from non-IRA accounts — such as 401(k), SEP-IRA, or Keogh plans — are taxed depending on whether you receive them in the form of an annuity (paid over your lifetime) or a lump sum. The amount you fill in on your 1040 tax return is reported on a 1099-R that you receive from your employer or another custodian of your plan, which may include an investment company, such as a mutual fund company or discount broker.
If you made nondeductible contributions to your retirement plan or contributions that were then added to your taxable income on your W-2, you aren’t taxed when withdrawing these contributions because you’ve already paid tax on that money. The rest of the amount you receive is taxable.
Understanding form 1099-R for non-IRAs
You report non-IRA retirement account distributions on Form 1099-R, which is the same one you use to report IRA distributions. Sometimes people panic when they receive a 1099-R, and they intend to rollover their retirement account money into a fund from, say, their employer’s retirement plan after they leave their job. Don’t worry. You received this form because you did do a legal rollover and, therefore, won’t be subjected to the tax normally levied on distributions.
The following list highlights how some of the other boxes on distributions for non-IRA retirement accounts come into play:
Box 3: If the distribution is a lump sum and you were a participant in the plan before 1974, this amount qualifies for capital gain treatment.
Box 4: This box indicates federal income tax withheld. (You get credit for this amount when you file your tax return.)
Box 5: Your after-tax contribution is entered here.
Box 6: Securities in your employer’s company that you received are listed here. This amount isn’t taxable until the securities are sold.
Box 7: Your employer enters a code that explains the type of distribution you’re receiving and why you’re receiving it. (See the back side of your Form 1099-R for an explanation of the code.)
Box 8: If you have an entry here, seek tax advice.
Box 9a: This amount is your share of a distribution if there are several beneficiaries.