Close

    What You Need to Know About Mutual Funds and Taxes

    by T. Rowe Price Investment Services

    What You Need To Know About Mutual Funds And Taxes Splash image

    Mutual Funds and Taxes

    With the holidays over, the tenor of the mail you are receiving has changed drastically—from holiday greeting cards to tax report statements.

    If you are a mutual fund shareholder, you will have received tax reporting statements with information on each individual fund by late January. These statements include information that the fund reports to the IRS on Forms 1099-DIV and 1099-B. Taxpayers report this information to the IRS on their income tax returns, Form 1040, with each fund reported separately, even if it is within the same mutual fund family.

    What do you need to know about these reports and the overall tax aspects of mutual fund investing?

    This article reviews the principal ways in which tax matters affect your mutual fund investments, and what you should understand about your mutual fund tax report statements.

    Distributions

    Mutual fund distributions are taxable whether you take them in cash or reinvest them. There are two exceptions:

    • Income dividends from municipal bond funds are usually exempt from state and local taxation, depending on what portion of the fund’s assets were invested in a particular state.

    • Income dividends and net capital gains distributed to IRA and other retirement accounts are tax-sheltered until withdrawn.
    Tax Note: Because distributions are taxed even if they are reinvested, it is important to remember that you should add reinvested income dividends and capital gains (from both taxable and tax-free funds) to your original cost basis when it comes time to figure gains or losses on shares sold.

    Distributions are taxable for the year in which they are paid. However, the tax law states that mutual fund dividend or capital gain distributions declared within the last three months of the year but paid the following January are taxable as though they were paid on December 31. Therefore, such distributions are included on IRS Form 1099-DIV, mailed to mutual fund shareholders in January.

    Form 1099-DIV

    In late January, mutual funds send out Form 1099-DIV to both shareholders and the IRS. What does this information include? For mutual fund investors, it may include the following:

    • Box 1 (Ordinary Dividends) reports a combined total for dividend income and short-term capital gains (since short-term gains are taxed at ordinary income tax rates). These amounts are reported on Line 9 of Form 1040 or 1040A, and on Line 5 of Schedule B of your Form 1040 (or Schedule 1 of Form 1040A) if required.

    • Box 2a (Total Capital Gain Distributions) reports net long-term capital gains. The sum of all long-term capital gain distributions from all sources is reported on Line 29 of Schedule D of Form 1040, unless you qualify for the Schedule D reporting exception, in which case long-term capital gain distributions may be reported on Line 13 of Form 1040; on Form 1040A it is reported on Line 10.

    • Box 2c (Qualified 5-Year Gain) reports gains that may be taxed at an 8% capital gains rate, depending on your income tax bracket. [This new rule, effective January 1, 2001, is explained in the next section on capital gains tax rates.] To calculate qualified five-year gains, use the Qualified 5-Year Gain Worksheet found in the IRS Instructions for Schedule D Capital Gains and Losses.

    • Box 3 (Nontaxable Distributions) reports any part of your distribution that is nontaxable because it is a return of your cost. You must reduce your cost basis by this amount when determining gains or losses when you sell your shares. [This is discussed further in the section on Nontaxable Distributions.]

    • Box 6 (Foreign Taxes Paid) reports taxes paid to foreign governments as a result of fund investments in that country. You may be able to claim this as a deduction or as a credit on Form 1040. This amount is also included in Box 1.

    Capital Gains

    For mutual fund shareholders, there are two potential sources of capital gains:

    • Mutual fund distributions: Mutual funds distribute their annual net capital gains to shareholders on a pro rata basis. The fund notifies the shareholder as to whether the gains are long term or short term (remember that short-term gains are treated as ordinary income). The status of any capital gain distributed to you by a mutual fund depends on how long the fund owned the securities that produced the gain—not on how long you owned shares in the fund.

    • Shareholder Transactions: Shareholders can also generate capital gains by selling or exchanging shares in mutual funds (except money funds, which are managed to maintain a stable share price).

    The rate that applies to your sale of mutual fund shares depends on how long you held the shares. Short-term capital gains for securities held one year or less are taxed at ordinary income rates, which could be as high as 39.1% at the federal level. Long-term gains (on securities held more than one year) are taxed at 20% (or 10% for investors in the 15% bracket) and 25% for gains on certain real estate transactions.

    Starting in the year 2001, you may get a tax break on capital gains realized on assets held at least five years, depending on your income tax bracket:

    • For taxpayers in the 15% income tax bracket, capital gain rates drop to 8% from 10% currently for assets (including mutual fund shares) held at least five years and sold after December 31, 2000.

    • For taxpayers in tax brackets above 15%, capital gain rates will drop to 18% from 20% for assets held at least five years and purchased after December 31, 2000. This means that the lower rate would apply only to capital gains realized after December 31, 2005.

    Capital Losses

    The tax treatment for capital losses depends on the source:

    • Shareholder Transactions: Investors can use their capital losses from fund transactions to offset capital gains from other sources. Any net capital losses can be used to offset ordinary income dollar for dollar up to $3,000 (or $1,500 if married but filing separately) in any one year. Unused losses can be carried forward indefinitely. (For more information, see IRS Publication 564.)

    • Mutual Fund Transactions: The fund’s capital losses are never distributed to shareholders, but are used to offset capital gains realized the by the fund during the year. Any additional losses are carried forward by the fund to apply against gains realized in the future. The only losses you can claim are those you may have incurred when you redeemed your own shares of a fund.
    Tax Note: If you realize a capital loss on mutual fund shares held less than six months and you received a long-term capital gain distribution from the fund while you held those shares, only the portion of your loss that exceeds the amount of the distribution can be reported as a short-term loss. The portion that is equal to or less than the distribution is long term.

    Redemptions or exchanges

    Unless you are conducting transactions in a tax-sheltered retirement plan, an exchange of assets from one fund to another is the same as a sale and purchase for tax purposes. In January, each mutual fund reports proceeds of sales (redemptions or exchanges) made during the year to the IRS and to you on Form 1099-B. The 1099-B does not need to be attached to your Form 1040, but that data on it should match what you report on Schedule D.

    Calculating Gains & Losses

    The IRS allows three methods for determining the cost basis—first in, first out (FIFO), average cost, and specific identification. You will need to keep copies of your year-end statements or confirmations to accurately calculate your cost basis.

    If you do not specify a method for calculating cost basis, the IRS assumes that you use the FIFO approach, where the shares sold are the ones you have held longest. While this is easy to calculate, this method often leads to the largest capital gains, since the longer you hold shares, the more time they have to appreciate.

    The average cost approach, which is the most commonly used, has two variations: double-category and single-category. With the former method, you divide your shares into two groups: those held longer than one year (long-term shares) and those held one year or less (short-term shares). You then figure the average cost per share for each group.

    With the single-category method, you figure the average cost per share for all shares held in the account, and any shares that are sold are considered to be those held longest in the account.

    An example of the average cost single-category approach is detailed in Table 1, which assumes an initial investment of $10,000 made at the end of 2000, two additional investments of $1,000, and all dividends and capital gains reinvested in a hypothetical stock fund. These reinvestments are included in your cost basis.

    Table 1. Determining Tax Basis Using Average Cost Single-Category Method: Stock Fund
    Date Transaction Amount
    ($)
    Price
    ($)
    No. of
    Shares
    (No.)
    Cumulative
    Tax
    Cost
    ($)
    Average
    Cost
    (Tax Basis)
    ($)
    12/30/00 Investment $10,000.00 $18.67 535.6 $10,000.00  
    1/20/01 Dividend Dis 267.8 17.74 15.1 10,267.80  
    1/20/01 Capital Gain Dis 455.26 17.74 25.7 10,723.06  
    3/31/01 Investment 1,000.00 19.48 51.3 11,723.06  
    Current Balance       $627.70 $11,723.06 18.68
    6/2/01 Sale $2,500.00 $19.90 -125.6 -2,346.21  
    Current Balance       $502.10 $9,376.85 18.68
    6/29/01 Dividend Dis 1,205.04 18.03 66.8 10,581.89  
    7/19/01 Dividend Dis 210.49 19.09 11 10,792.38  
    7/19/01 Capital Gain Dis 312.89 19.09 16.4 11,105.27  
    9/29/01 Investment 1,000.00 21.49 46.5 12,105.27  
    Current Balance       642.80 $12,105.27 18.83
    11/20/01 Exchange $2,000.00 $19.32 -103.5 -1,948.91  
    Current Balance       $539.30 $10,156.36 18.83

    On June 2, 2001, the investor redeemed $2,500 (125.6 shares). The tax cost and capital gain or loss on this transaction are figured in the following steps:

    1. Divide the cumulative tax cost (the sum of all investments made prior to the sale) by the total shares in the account to determine the average cost per share: $11,723.06 cumulative tax cost ÷ 627.7 shares = $18.68 average cost per share

    2. Multiply the number of shares redeemed by the average cost to determine the tax cost of the shares sold: $18.68 average cost × 125.6 shares = $2,346.21 tax cost on shares sold

    3. Subtract the tax cost from the sale proceeds to determine the capital gain or loss on the shares sold: $2,500.00 sale proceeds - $2,346.21 tax cost = $153.79 capital gain
    Since the shares sold with the average cost method are considered to be those acquired first, and all the shares in this example were acquired within a one-year period, the $153.79 would be a short-term capital gain under current rules. The investor’s new cumulative tax cost after the sale is $9,376.85 ($11,723.06 - $2,346.21); the average cost per share remains $18.68.

    On November 20, 2001, the investor exchanged $2,000 (103.5 shares). Exchanges from one fund to another are treated the same as any purchase or sale for tax purposes. The cumulative tax cost prior to this second transaction is $12,105.27. Dividing this by the 642.8 share balance produces an average cost per share of $18.83.

    Multiplying $18.83 by the 103.5 shares exchanged produces a tax cost of $1,948.91. Since these shares were held less than one year, the $51.09 capital gain ($2,000 - $1,948.91) would be considered short term.

    Under the specific identification method, you may specify which shares have been sold, identifying them by the trade date on the confirmation statement. The tax cost is the specific cost of those particular shares. However, if you want to use this approach, you must give the fund written instructions at the time of sale specifying which shares are to be sold.

    Some fund companies will furnish your cost basis and your capital gain or loss for shares redeemed during the year. In most instances, the method they have used is the average cost single-category method. This information is not reported to the IRS, and you are not obligated to use it.

    Although the example above used a hypothetical stock fund as an example, the procedure for calculating your tax basis is no different for a fixed-income, non-money-market fund (money market funds are managed to maintain a constant share price, so transactions generate neither gains or losses).

    Tax Note: If you have never sold shares of a particular investment, you may choose any method—FIFO, average cost, or specific identification—for determining your capital gain or loss when a sale occurs. The selection of average cost must be indicated on your tax return and, once selected, you cannot switch to a different method for that particular fund without IRS consent.

    Information on determining the cost basis of mutual fund shares is available in IRS Publication 564.

    Wash Sales

    Wash sale rules apply to mutual funds. If you sell shares at a loss, you can’t claim the loss if you purchased other shares in the same fund within 30 days before or after the sale.

    Tax-Free Funds

    The income you receive from a municipal bond fund is exempt from federal income taxes, and income earned on bonds issued by the state or locality in which you reside or pay taxes is generally exempt from taxation in that state. (Income from certain “private purpose” bonds may be subject to the alternative minimum tax, which will be discussed shortly.)

    Capital gains distributed by the fund or resulting from your own sales of shares in a tax-free fund are subject to federal and most state capital gains taxes. Some states do not tax gains earned on their own securities. (Consult your local taxing authority.)

    The alternative minimum tax (AMT) may apply to those who have substantial tax deductions or derive substantial income from so-called “tax preference” items—incentive stock options, certain private purpose municipal bonds, and other types of tax-sheltered investments. Income from these items generally must compose a significant percentage of the taxpayer’s total income from all sources before triggering AMT liability. Only a very small percentage of all taxpayers pay the AMT.

    At year-end, your fund should notify you of the percentage of fund dividends, if any, that was derived from tax preference items for AMT purposes. (This information is not reported to the IRS.) Instructions for IRS Form 6251 provides more information to determine if you are subject to the tax.

    Unless your tax-exempt fund made a capital gain distribution during the year, you will not receive a Form 1099-DIV, since income dividends from tax-free funds are exempt from federal taxation. Any distributions of short-term capital gains are reported as “ordinary income” on Form 1099-DIV.

    Although tax-exempt dividend income paid to you is not reported to the IRS by the fund, you must report it (on Form 1040, Line 8b) along with any other tax-exempt interest you may have received during the year. This information is used to determine the tax status of any Social Security payments you may have received. Your year-end fund statement lists the annual total of tax-exempt income distributions.

    In addition, at year-end your tax-exempt fund should provide information regarding the percentage breakdown of your fund’s earnings by state. Most states tax income earned on out-of-state municipal bonds; your state’s taxing authority can provide more information regarding the tax treatment of municipal bond income.

    Tax Note: If a tax-free bond fund buys a municipal bond at a discount (at a price below par) and sells it for a profit, a portion of that capital gain may be taxed at the investor’s ordinary income tax rate, provided the discount is sufficiently large. The gain cannot be offset by any capital losses.

       Recordkeeping and Specific Identification
    If you have sold mutual fund shares using the specific identification method, it is important that you have the proper documentation for your tax records

    According to the IRS, you will adequately identify your specific mutual fund shares if you:

    • Specify to your broker or fund in writing the particular shares to be sold or transferred at the time of sale or transfer, and
    • Receive written confirmation of your specification from your fund or broker within a reasonable time.
    Be sure to keep a copy of the dated letter sent to your broker or fund, and make sure that the letter specifies exactly which shares you are seeking to sell.

    For example, assume you own 450 shares of mutual fund XYZ. You purchased 250 shares at $10/share in February of Year 1, and 200 shares at $14/share in July of Year 2.

    Now, in Year 3, the fund shares are at $15/share, and you want to sell 200 shares, and you want to specifically identify the later shares that you purchased as those that were sold, in order to produce the lowest tax bill.

    You should send dated, written instructions to your broker or your mutual fund stating that you wish to sell the 200 shares that you purchased in July of Year 2 for $14/share.

    In addition, you should receive written documentation back from your broker or fund confirming that specific shares were sold.

    International investments

    When a fund must pay taxes to foreign governments, which often results when funds invest in the securities of foreign companies, the non-refundable portion paid on your behalf is reported in Box 6 of your 1099-DIV and is also included in Box 1. When you file your U.S. tax return, you may use this amount either as a direct credit against taxes due (usually the more advantageous approach), or as an itemized deduction. You can only take the credit if you held the fund shares for 16 days during the 30-day period beginning 15 days before the fund’s ex-dividend date. Your fund should send you all the information you need for tax reporting purposes, including a percentage breakdown of income by country.

    U.S. Government Obligations

    States do not tax income earned on direct U.S. government obligations. However, if the income was derived from a mutual fund, some states require that a minimum percentage of the fund’s assets—usually 50%—be invested in these securities to qualify for the exemption.

    In January, your fund will notify you of the percentage of the fund’s income distributions earned from U.S. government securities and which funds had more than 50% of their total assets invested in such issues.

    Nontaxable Distributions

    When a fund pays out more income than it earned during the course of a year on a tax basis, the excess is called “return of capital” and is reported on Form 1099-DIV as a nontaxable distribution. You should subtract any such amounts for the cost basis of your shares.

    For example, if at year-end, foreign currency trading losses are found to have offset income already paid out in an international bond fund, the excess income distributions would be reclassified as a nontaxable return of capital.

       IRS Information
    For further information on tax matters, you can go directly to the IRS:

    General Info: 1-800-TAX-1040

    To Receive Federal Tax Forms:
    By Phone: 1-800-TAX-FORM (829-3676)
    On-line:www.irs.ustreas.gov.

    The following IRS Publications may be particularly useful to mutual fund investors:

      IRS Pub’l
    Mutual Fund Distributions 564
    Individual Retirement Arrangements 590
    Foreign Tax Credit for Individuals 514


    This article is based on excerpts from “Tax Considerations for Investors,” and “Tax Information for Mutual Fund Investors,” copyright 2001, by T. Rowe Price Investment Services; 100 E. Pratt St., Baltimore, Md. 21202; www.troweprice.com. The excerpts are used with permission.


→ T. Rowe Price Investment Services