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Double-Paying Mutual Fund Taxes Prevention


If you are part of a stock fund and your fund manager has purchased a new stock, after it has grown sufficiently to be sold, you should pay taxes on the acquired dividend distributions. On the other hand, you can also receive capital gains distribution, which is associated again with taxation but at capital gains rates. You are subject to taxation even if you have owned a mutual fund for as short a period as a month. This is caused by the fact that the fund pays long-term capital gains on an asset that has been held enough to be sold.

Mutual Fund Tax Overpayment

Reinvestment of the acquired dividends or capital gains often leads to double-paying of taxes. The following example clarifies how this happens.

John's $20,000 investment in Fund X, returns 7% annual dividend. As a result, John receives $1400, which he automatically reinvests and gets more shares of the mutual fund. Eventually, taxes will be levied on the gained $1400.

At the end of the third year, John will have $4,200 in dividends (excluding the notion of compounding for the purpose of simplicity). Every year during this period he will pay the corresponding taxes. Finally, at the end of the third year he has $24,200, which represents the value of his mutual fund. If John decides to sell his fund, he should not pay any taxes since he has done this during the time period and thus he will receive $24,200 straight away.

Unfortunately, most investors fall in the common trap of paying again taxes on the profit they acquire after selling the fund. They forget that they have already paid their liabilities to Uncle Sam, since every year during the time period they have paid taxes on the realized dividends or capital gains.

How to Avoid Double-Paying

Follow these simple steps and you sufficiently increase your chances of not double-paying your mutual fund tax liabilities.

  1. Do not throw your mutual fund statements
  2. Give your tax preparer the collected mutual fund statements.

Therefore, referring back to the previous example, when John is asked about the amount he has invested, he should state $24,200 instead of $20,000 in order to avoid double-paying. Even the better alternative is to let the tax preparer figure for himself the exact amount by reading the mutual fund statements. That's what you have hired him for!

Part Investment Sale Taxation

Part-investment selling is a possibility that exists with mutual funds. To better understand it, let's consider the following example. Kate owns 600 shares for a total of $12,000 (price per share = $20). These shares have been accumulated over a five-year time period. Kate needs $3,000 to pay her son's school tuition. Therefore, she decides to sell 150 shares to cover this expenditure. Now, she has to make the choice exactly which shares to sell.

When tax time comes Kate will feel the consequences of her choice. Why is this? Since the gains on the shares she has purchased first may be greater, because she has held them for the longest time, she may face higher taxes if she has decided to sell them. On the other hand, the sale of the most recently purchased shares does not represent a good option either since their sale may be considered as a Short-Term. Therefore, those purchased sometime in the middle, may represent the best candidates, but still Kate should carefully consider the current situation on the market.

Never forget that you have the option to choose, which shares to sell. Unfortunately, once you have made a decision on the method you are to apply, you have to stick to it. You are not allowed to change it in accordance to the particular investments made. Finally, be careful in choosing your selling technique of the shares, since it will greatly influence your tax liabilities.

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