Mutual funds can have a complicated effect on income tax and can create undesirable year-end surprises if purchases or sales are poorly timed.
For mutual fund investors, taxes are based on activities within each fund (with the exception of qualifying retirement plans). Any income or gain must be passed on to shareholders when a fund investment generates taxable income or the fund sells one of its investments. On the date the proceeds are distributed to shareholders, the taxable event will take place. Each shareholder will then owe tax on their portion.
The value of undistributed earnings that have previously accrued within the fund may be included in your cost if you buy mutual fund shares toward the end of the year. Should the fund then distribute those earnings at year-end, you’ll pay tax on your share even though you paid for the built-up earnings when you bought the shares. Furthermore, if the fund sold investments during the year at a profit, even if you didn’t own the fund at the time the investments were sold, you will be taxed on your share of its year-end distribution of the gain.
When considering buying a mutual fund late in the year, ask if it’s going to make a large year-end distribution, and if so, wait until the distribution is completed before making the purchase. On the other hand, ensure your entire profit will be treated as long-term capital gain and sell before scheduled distribution when you’re selling appreciated shares that you’ve held for over a year.
Contact our office if you are considering buying or selling mutual funds and would like further information about the tax effects.