These common transactions can result in unanticipated mutual fund share sales — and a tax surprise

This article was originally published on this site

In last week’s Tax Guy column, I pointed out that one big negative about equity mutual funds is that you don’t have much control over taxes. The fund decides which investments to sell and when. If the fund sells investments that have gone up in value since they were acquired, the resulting gains will be passed out to you in the form of dividend distributions.

If you hold your fund shares in a taxable brokerage firm account, those distributions will be taxable. The tax rate you will pay depends on your income level, whether the gains were short-term or long-term, and whether proposed tax rate increases become reality.

Biden’s proposed tax rate increases

Starting in 2022, the proposed Biden tax plan would raise the top federal income tax rate on net short-term capital gains recognized by individuals, including those from mutual fund distributions, back to 39.6%, the top rate that was in effect before the Tax Cuts and Jobs Act lowered it to the current 37%.

This proposed rate increase would affect singles with taxable income above $452,700, married joint-filing couples with taxable income above $509,300, and head of households with taxable income above $481,000. After tacking on the 3.8% net investment income tax (NIIT), the maximum effective rate would be 43.4% (39.6% + 3.8%) versus the current maximum rate of 40.8% (37% + 3.8%).

The proposed Biden tax plan would also increase the maximum federal rate on net long-term capital gains, including those from mutual fund distributions, to 39.6% for gains recognized after April of this year, though the exact timing is still unclear. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%).

The proposed rate increase would only hit taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000 if you use married filing separate status, so you might not be affected. If you are, you pay the higher maximum rate only to the extent that your AGI exceeds the applicable threshold. For example, a married joint-filing couple with AGI of $1.2 million, including a $300,000 net long-term capital gain, would pay the 39.6%/43.4% maximum rate only on the last $200,000 of net long-term capital gain. Will this proposed retroactive near-doubling of the maximum effective federal rate on long-term gains get through Congress? We shall see.

But there’s more to consider beyond just current and future tax rates. Here’s the rest of the story about mutual funds and taxes.

Who made a sale? Not me!

As with regular stock shares, you can make outright sales of mutual fund shares. When you make an outright sale, you are (I hope) well aware that you must figure the amount of your capital gain or loss for tax purposes. The tricky part is that mutual fund companies allow investors to make other transactions that are also treated as taxable sales. The added convenience of being able to make these transactions is great, as long as you understand the tax ramifications. Here are two common transactions that can result in unanticipated mutual fund share sales.

  • Your fund company allows you to write checks against your account with the cash coming from liquidating part of your investment in fund shares. When you take advantage of this convenient arrangement, you’ve made a sale, and you must calculate the resulting capital gain or loss for tax purposes.
  • You switch your investment from one fund in a mutual fund family (Fidelity , T. Rowe Price, etc.) to another fund in the same family. Once again, this is a taxable sale.
The ex-dividend factor

Equity mutual funds generally distribute all (or almost all) of their annual capital gains to avoid having to pay the corporate income tax on those gains. This can result in large fourth quarter taxable dividend distributions. Based on this year’s stock market results so far, some of this year’s distributions could be unusually large. And they could be paid out as early as sometime in November, which will be here before you know it.

If you own shares on the mutual fund’s dividend date of record, you will receive the upcoming dividend. The ex-dividend date is usually the day after the date of record. If you buy in on or after the ex-dividend date, you will not receive the upcoming dividend. The actual dividend payment date is usually a few days after the ex-dividend date. For example, a fund may schedule its 2021 fourth-quarter dividend to be paid to owners of record as of 11/29/21. So, the dividend date of record is 11/29. The ex-dividend date will probably be 11/30. The actual dividend payment date might be 12/3.

If you are considering buying into a fund

If you buy into a mutual fund shortly before the ex-dividend date, you will get the upcoming dividend distribution, but you will also get the tax bill that comes with it. So, you wind up paying taxes on gains earned by the fund before you were even a shareholder. Not good.

Some of the upcoming distribution may consist of long-term capital gains and qualified dividends from stocks held by the fund. The federal income tax rate on that portion of the distribution can be up to 20%, plus another 3.8% for the NIIT, assuming no retroactive tax rate hikes. Some of the upcoming distribution may consist of short-term capital gains and interest. The federal income tax rate on that portion can be up to 37%, plus another 3.8% for the NIIT, assuming no retroactive tax rate hikes. you may owe state income tax too, depending on where you live.

Example: The ZOOM Fund declares a $5 per share fourth-quarter dividend to owners of record as of 11/29/21. So, the dividend date of record is 11/29. The ex-dividend date is 11/30. The dividend will be paid on 12/3.

On November 25, you decide to invest $40,000 from your taxable brokerage firm account to buy 1,000 shares of ZOOM at $40 per share. Since you buy in before the 11/30 ex-dividend date, you will receive the upcoming dividend of $5 per share (total of $5,000). Other things being equal, the per-share price of ZOOM will drop by $5 on 11/30 (the ex-dividend date) to reflect that fact that incoming shareholders won’t get the upcoming dividend and to reflect the reduction in the fund’s net asset value (NAV) due to paying out that dividend.

So, assuming no other influences on ZOOM’s price, the shares will be selling for $35 on 11/30. However, you paid $40 for your shares, plus you are on the hook for taxes on the upcoming $5,000 dividend. If you had waited just a few days and bought in on or after the 11/30 ex-dividend date, you could have sidestepped the dividend, and the related tax hit, and bought more shares with the same $40,000 investment. Oops.

To avoid the tax problem illustrated in the preceding example, you should have contacted the fund to find out the next ex-dividend date and the expected dividend amount. Then you could have bought in on or after the ex-dividend date.

If you are considering selling fund shares

If you are considering selling some appreciated mutual fund shares that you’ve owned for more than one year, the resulting profit will be a long-term capital gain. As such, the maximum federal income rate will be “only” 20%, assuming no retroactive tax rate hike for this year. You may owe the 3.8% NIIT too as well as state income tax depending on where you live.

If you sell before the fund’s ex-dividend date, you won’t receive the upcoming dividend distribution, and your entire profit will be a lower-taxed long-term capital gain, as long as you’ve held the shares for more than one year.

On the other hand, if you sell on or after the ex-dividend date, you will receive the upcoming dividend distribution. Part of that distribution may consist of high-taxed short-term capital gains. If so, the tax hit will be that much higher.

The bottom line

As you can see, mutual fund distributions can have important tax implications, and that is especially true for fourth quarter distributions. This year, the issue will likely have even greater significance because funds that have benefitted from the strong stock market will probably be making bigger-than-normal distributions.

Finally, remember that none of this tax stuff matters for mutual fund shares held in tax-advantaged accounts like traditional IRAs, Roth IRAs, SEPs accounts, and 401(k) accounts. With those accounts, you only owe taxes when you take withdrawals. Until then, gains and losses that accumulate in your account have no tax impact.