You don’t need to worry about year-end distributions with individual stocks. But with mutual funds you absolutely need to worry. It’s why at Young Research we favor individual stocks in both our Retirement Compounders and Maximizers investment strategies. Here’s a primer on year-end distributions courtesy of Fidelity. Pay particular attention to tax strategies for mutual funds, or avoid it all together by owning stocks.
Mutual Funds and Taxes
Distributions from mutual funds occur for several different reasons and are subject to differing tax rates. Many mutual funds bundle most of their payouts into single, net distributions at the end of each year.
Whenever a mutual fund company passes earnings and other payouts to shareholders, it’s known as a distribution. The major distribution for most funds comes at the end of each year, when net amounts are calculated—capital gains and other earnings minus the expenses of running the funds.
It’s up to you to report mutual fund transactions on your tax return, as well as pay the appropriate taxes on each type of fund income.
Distributions and your taxes
If you hold shares in a taxable account, you are required to pay taxes on mutual fund distributions, whether the distributions are paid out in cash or reinvested in additional shares. The funds report distributions to shareholders on IRS Form 1099-DIV after the end of each calendar year.
For any time during the year you bought or sold shares in a mutual fund, you must report the transaction on your tax return and pay tax on any gains and dividends. Additionally, as an owner of the shares in the fund, you must report and potentially pay taxes on transactions conducted by the fund, that is, whenever the fund sells securities.
If you move between mutual funds at the same company, it may not feel like you received your money back and then reinvested it; however, the transactions are treated like any other sales and purchases, and so you must report them and pay taxes on any gains.
For federal tax purposes, ordinary income is generally taxed at higher rates than qualified dividends and long-term capital gains. The chart below illustrates how each type of mutual fund income is taxed.
Type of distribution Definition Federal income tax treatment Long-term capital gains Net gains from the sale of shares held for more than one year; may include some distributions received from investments held by the fund Subject to the capital gains rates, usually lower than the ordinary income tax rates Short-term capital gains Net gains from the sale of shares held for one year or less May be treated as ordinary dividends, thus taxable at ordinary income tax rates Qualified dividends Dividends from common stock of domestic corporations and qualifying foreign corporations Normally taxed as long-term capital gains (subject to certain holding period and hedging restrictions) Ordinary or non-qualified dividends Investment income earned by the fund from interest and non-qualified dividends minus expenses; often used as a blanket term that includes all taxable income except long-term capital gains. Taxable at ordinary income tax rates Tax-exempt interest Some or all interest on certain bonds, usually state or local municipal bonds, designated as tax-exempt Not taxable for federal tax purposes; may be subject to state and/or local taxes, depending on your resident state and the type of bonds purchased Taxable interest Interest on fixed-income securities Taxable at ordinary income tax rates Federal interest Interest on federal debt instruments Taxable at ordinary federal income tax rates, but exempt from state income tax Required distributions Non-investment income required to be distributed by the fund (such as foreign currency gains that are taxed as ordinary income when distributed) Taxed as ordinary income Return of capital A portion of your invested principal returned to you Not taxable
When there is no distribution
If a mutual fund does not have any capital gains, dividends, or other payouts, no distribution may occur. There may also be a non-taxable distribution. Shareholders will not be required to pay taxes if the fund has not made a taxable distribution, and shareholders will not receive a Form 1099-DIV for that fund.
When distributions are paid
Each fund’s prospectus outlines its distribution policy. A summary of policies for Fidelity-issued funds is below.
Type(s) of funds Type of distributions When paid Equity and bond funds Capital gains After fiscal year-end and at calendar year-end Money market and most bond funds Income dividends Monthly Growth and income funds Income dividends Quarterly Growth funds Income dividends After fiscal year-end and at calendar year-end
Some fixed income funds that distribute investment income daily may be required to distribute additional income at the end of December. This income usually consists of amounts earned in addition to regular interest income, such as market discount and dividends.
Tax strategies for mutual funds
1. Consider the timing of fund purchases and sales relative to distributions
Year-end fund distributions apply to all shareholders equally, so if you buy shares in a fund just before the distribution occurs, you’ll have to pay tax on any gains incurred from shares throughout the entire year, well before you owned the shares. This could have a significant tax impact.
Selling a fund prior to the distribution will generally result in more capital gain or less loss than if you sell the shares after the distribution, if you only take into account market price changes reflecting the distribution. Selling shares after the distribution usually will yield less gain or more loss.
If you are considering a purchase or sale around the time of a distribution, there are many other factors to consider, including the size of the dividend relative to the size of your expected investment and how the transaction may fit in your overall tax strategy. Consult a tax or other advisor regarding your specific situation.
2. Consider the fund’s turnover rate
Since a capital gain must be reported each time a purchase or sale of shares is made, funds that trade securities in and out very frequently may be apt to accumulate more taxable gains. Additionally, trading fees associated with this activity may also increase costs, cutting into net earnings.
Fidelity offers Index Funds, which tend to have lower turnover than actively managed funds. You can also use the Fund Evaluator in Mutual Funds Research and include turnover as a factor in your search criteria (located in the advanced criteria under Fund Management).
Again, taxes are only one of many factors you should consider when choosing a mutual fund. Consult a tax or other advisor regarding your specific situation.
Originally posted on Your Survival Guy.