If you hold shares in a mutual fund, there are two ways you can wind up paying capital gains tax. In fact, you might have to pay capital gains tax even if your mutual fund stake decreases in value.
Mutual fund shares typically are not traded on an open market. When you buy shares of a mutual fund, they are issued by the mutual fund company at a cost determined by the net asset value -- NAV -- of the fund. The company determines each day's NAV by adding up the cash and the market value of all the securities the fund owns, subtracting the fund's liabilities and dividing by the number of shares issued. You also can obtain shares by reinvesting the fund's distributions. Mutual funds make periodic distributions from the income derived from dividends paid by securities held in the fund and through capital gains -- selling fund-owned securities at a higher price than the fund paid to buy them. When a fund makes a distribution, its NAV drops in proportion to the amount paid. For example, if the fund pays 1 cent per share as a dividend distribution, the NAV will drop by 1 cent.
You redeem your shares by turning them back into the issuing company at that day's NAV. If the NAV is higher than when you bought the shares, you have a capital gains tax liability. If you buy shares at different times and your redemption involves only a portion of your shares, there are several ways to figure your cost basis: actual cost basis, in which you specifically identify the shares you want to sell; first in, first out basis, in which you use the actual cost of the shares but the fund assumes you want to sell first the shares you've held the longest; and average cost basis, in which you calculate the average price per share by dividing the total purchase price for all shares, including those bought through reinvested income, by the number of shares owned. There are two ways to figure average cost. The single category method combines all shares with your capital gain figured using the date of the oldest shares sold. The double category separates the shares into those held more than a year -- long-term capital gain -- and those held less than a year -- short-term.
Long-Term Capital Gain Distributions
When you buy shares in a mutual fund, you choose whether to reinvest your distributions for more fund shares or take the distributions in cash. But even if you choose to reinvest a long-term capital gain distribution, it must be included as part of your taxable income in the year you receive the distribution. It will be taxed at the long-term capital gains tax rate -- 15 percent as of publication.
Although most capital gains distributions are long term, actively managed funds in particular also incur short-term capital gains from securities held less than a year by the fund. Short-term capital gains distributions are taxed as ordinary income.
Reporting Distribution Capital Gains
The mutual fund company will issue you a 1099-R, breaking down the fund distributions by category. You may be liable for taxes on a capital gains distribution, even if the fund's NAV decreases. Look at it as reducing future taxes. A simple example: You pay $10 for Best Choice mutual fund. You receive a 10-cent per share cash distribution for the fund's capital gains, reducing the fund NAV to $9.90. Although you would have to pay capital gains tax on the distribution, you could redeem the fund shares immediately and incur a 10-cent capital loss on the sale, effectively neutralizing the distribution.
Closed-end mutual funds also hold a basket of securities, but the fund has a specific number of shares, which are sold on the open market. Capital gains on closed-end funds are computed the same as those for company stocks.
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