Too often taxpayers receive tax surprises at year-end due to
actions taken by mutual funds they own. What can add insult to injury is
the unsuspecting taxpayer who recently purchases the shares in a mutual
fund only to be taxed on their recent investment. How does this happen and
what can you do about it?
Tax surprises
Towards
the end of each year, many mutual funds pay a dividend to the holders on
record as of a set date. The fund might also distribute funds deemed as
capital gains based upon buying and selling activity that takes place in
the fund throughout the year. This can create many problems:
- Taxable paybacks. If you purchase shares in a mutual fund just
before a distribution of dividends, part of your purchase includes the
dividends that are effectively paid right back to you. Not only will
the asset value of your recently purchased shares in the mutual fund
go down after the distribution, but you will owe tax on a distribution
that is effectively your own money!
- Kiddie tax surprise. Many taxpayers purchase mutual funds in their
children’s names to take advantage of their lower-tax rates. By
keeping their child’s unearned income below $2,100 the tax is low or
non-existent. A surprise dividend or capital gain could expose much of
this unearned income to higher tax rates.
- The $3,000 loss strategy. Each year, you may take a net of up to $3,000 in
investment losses. Your losses can offset high rates of income tax
with correct tax planning. But first, these losses need to offset
capital gains. If you receive a surprise capital gain, you could be
reducing the effectiveness of this tax strategy.
What to do
Here
are some ideas to help reduce this mutual fund tax surprise:
- Limit year-end activity. Plan your mutual fund moves with this year-end
surprise in mind. Consider reviewing and rebalancing your funds at the
beginning of the year to avoid fund purchases just prior to dividend
distributions.
- Research your mutual funds. If you wish to avoid a year-end surprise, do a
little research on your mutual funds to anticipate what will happen
with the fund. Check out the historic trends of your funds to
determine which are most likely to issue a surprise Form 1099 DIV or
Form 1099 B (capital gain/loss).
- Use the knowledge to your benefit. If you like a fund and it has a practice of
creating taxable events each year, consider investing in these funds
within a retirement account. That way the tax implications can be part
of your retirement planning.
No
one likes a surprise at tax time. The best course of action regarding your
mutual funds is to consult with an expert who can help you navigate the
options that are best for you.
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