People often find investing in mutual funds easier than investing in individual stocks because mutual funds offer diversification and professional management. However, there are still tax penalties imposed on investors when selling out of a mutual fund. Understand what these are to avoid unpleasant surprises.
Mutual funds may hold many different stocks and bonds, so when you buy into a mutual fund, you’re essentially purchasing a professionally selected mix of stocks, bonds or both. That means that when you sell your ownership in the mutual fund, you’re essentially selling the stocks and bonds held by the fund. As such, you’re subject to some of the same tax penalties as if you were actually selling shares of individual stocks or bonds.
Differential Tax Treatment
In a tax-deferred account such as an individual retirement account, you may sell shares in a mutual fund to buy shares in another fund that is more appealing to you without tax penalty because your tax obligation is deferred. However, that’s not the case with a regular taxable investment account. In such cases, when you sell shares in a mutual fund, you must report gains or losses to Uncle Sam.
Different Types of Gains Taxed Differently
There are three ways in which your gains or losses from the sale of mutual fund shares can be taxed. When the fund invests in stocks that are then sold at a higher value, you get a gain, which is subject to capital gains tax. However, gains from stocks held for more than a year are taxed at a lower rate. Mutual funds may also get qualified dividends that get passed on to investors. These get taxed at a lower rate than ordinary income. Finally, some mutual funds hold government bonds, which can qualify for certain tax benefits. For instance, interest produced by municipal bonds is exempt from federal tax.
Investment returns from the sale of mutual fund shares get taxed each year. Your fund manager will send you an annual report that you use to report gains, and pay taxes, from the sale of mutual fund shares. Generally, you can expect to pay as much as 35 percent on interest income from bond or money market fund holdings; between zero and 15 percent (through 2012) on stock dividends; between zero and 15 percent (through 2012) on long-term capital gains; and as much as 35 percent on short-term capital gains. Specific amounts can vary depending on your individual tax bracket.
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