A Tax Upon Your Gains
It’s mutual funds distribution season. Many mutual funds will be calculating up their profits and distributing the capital gains to shareholders over the next two months. What many shareholders don’t understand, however, is that mutual fund capital gains tax is their responsibility, not the fund’s. How can you help your clients avoid tax surprises when they open up their IRS Form 1099-DIV in January? Here’s an overview of how mutual fund distributions work.
The Long and Short of Capital Gains and Mutual Funds
When you sell an asset – a security, for example – at a higher price than you bought it, you realize capital gains. Those gains are classified in one of two ways: short-term or long-term. Short-term gains are those realized on assets you own for one year or less. Gains on assets sold after the one-year mark are long-term.
As mutual funds sell securities, the fund passes profits from the sale to shareholders in the form of gains. Shareholders can take these distributions as cash or reinvest into additional shares. No matter which distribution method they choose, shareholders are responsible for paying tax on realized gains.
Show Us the Money
While short-term gains are taxed as ordinary income, long-term gains are taxed at 0%, 15% or 20%, depending on the shareholder’s tax bracket.1 Certain high income taxpayers may have to pay an extra 3.8 percent surtax on their long-term capital gains. Shareholders pay taxes on the gains even if they haven’t sold any of their fund shares in the previous year. It also doesn’t matter how long they’ve owned the shares; capital gains are calculated on the length of time the fund owned the securities.
If a fund’s realized gains exceed its realized losses, the fund must “spread the wealth” and make distributions to shareholders. Tax laws state distributions must be made annually, although the fund could choose a more frequent distribution schedule.
Frequently Asked Questions
One question your clients might ask: “Why am I showing gains when my mutual fund is down?” Capital gains and losses are tied to the sale of securities, not to overall fund or market performance. Even if a market is down, the fund might sell an appreciated asset, resulting in capital gains that exceed the fund’s losses.
Another possible point of confusion for your clients: Mutual funds also distribute ordinary dividends to shareholders. Unlike capital gains, funds pay ordinary dividends from dividends or interest generated by the investments in the mutual fund portfolio. And instead of long-term/short-term designations, ordinary dividends are always taxed at the investor’s regular income tax rate.
The Time is Now
As you’re heading into year-end portfolio reviews, one item for your checklist is to review mutual fund capital gains and losses with your client. Most mutual fund families will list their capital gains estimates on their websites in November, then pay them out in December. By gaining this information before client meetings, you can possibly eliminate tax surprises for the current calendar year. You might be able to sell other assets withinin your client’s investment portfolio and realize capital losses before year-end, offsetting gains and reducing your client’s tax bill.
1 IRS. Aug. 23, 2019. “Topic No. 409 Capital Gains and Losses.” https://www.irs.gov/taxtopics/tc409. Accessed Oct. 28, 2019.
1001040 – FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR USE WITH CLIENTS OR THE PUBLIC.
This content is provided for informational purposes only. The third-party information and opinions contained herein, have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by AE Wealth Management. At all times it must be clear to individuals that the advisory firm does not provide tax or legal advice. All individuals should be encouraged to seek the guidance of a qualified tax or legal professional.