Mutual Funds and Taxes: How To Cut Your Bill

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As a mutual fund owner, you may have to pay taxes on any income your shares generate. But how are mutual funds taxed when you sell? Being aware of your tax obligations whe you own a mutual fund can help you save money at tax time.

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What Is a Mutual Fund?

A mutual fund is an investment company that takes money from multiple investors and uses it to purchase securities, which are tradable assets such as stocks and bonds. An investor in a mutual fund purchases shares of the company and shares in the profits.

Many investors gravitate towards mutual funds because they are professionally managed and naturally diversified, which makes them a reliable investment option.

When Do You Have To Pay Taxes on Mutual Funds?

As a mutual fund shareholder, you may see two types of payouts: ordinary income dividends and capital gains distributions.

Ordinary Income Dividends

Mutual funds own assets that generate income from dividends and interest. Mutual fund managers divide the profits among the mutual fund’s shareholders as ordinary income dividends. This income is taxed as ordinary income at your tax bracket rate.

Your annual ordinary dividend amount is listed in box 1a of the Form 1099-DIV that your mutual fund sends you in January.

Capital Gains Distributions

When mutual funds sell an investment at a profit, the profit is divided among shareholders and distributed as a capital gains distribution. All capital gains distributions from a mutual fund are taxed as long-term capital gains.

Your annual capital gains distribution is listed in box 1b of Form 1099-DIV.

How Are Mutual Funds Taxed When You Sell?

Mutual funds are capital assets, so any profit from selling them is taxed as a capital gain. How that gain is taxed is determined by how long you’ve owned the mutual fund. If you’ve owned the share you’re selling for less than a year, the capital gain is taxed as ordinary income. If you’ve owned it for more than a year, that capital gain is taxed at 0%, 15% or 20% depending on your tax bracket.

How To Cut Taxes on Mutual Funds

Minimize the tax burden on your mutual fund using the following strategies.

Hold Your Mutual Fund for at Least a Year

The tax rate on capital gains is lower if you’ve owned the mutual fund for more than a year.

Invest in Mutual Funds Through Tax-Advantaged Accounts

You won’t pay taxes on dividends, capital gains distributions and capital gains from the sale of a mutual fund in a 401(k) or a traditional IRA until you withdraw the money after age 59 ½.

Any earnings from a mutual fund in a Roth IRA will grow tax-free.

Sell Your Mutual Funds When You Have Capital Gains Losses To Offset Them

If you have a capital gains loss in a tax year, you can use that loss to offset any capital gain from selling your mutual fund shares in a practice called tax-loss harvesting. For example, if you sell a boat at a capital loss of $10,000, but sell your mutual fund shares for $11,000, you’d only have to pay taxes on $1,000 of your gain.

Invest in Mutual Funds With Fewer Dividends or Capital Gains Distributions

Not all mutual funds deliver dividends or capital gains distributions. An index fund is a passive mutual fund that doesn’t buy and sell securities as often as other types of mutual funds, so you won’t receive annual capital gains distributions.

Final Take

You may have to pay income taxes on any dividends and long-term capital gains on any capital gains disbursements from a mutual fund. You’ll owe capital gains taxes on any profits from selling your shares. By planning ahead, however, you can minimize your final tax liability.

FAQ

Here are some answers to other commonly asked questions about mutual funds and taxes.

• How much tax do you pay when you sell mutual fund?
  • How much tax you pay when you sell mutual funds depends on how long you’ve owned shares in the mutual fund. If you’ve owned the share for less than a year, it will be taxed as ordinary income. If you’ve owned the share for more than a year, it’s taxed as a long-term capital gain.
• How do you avoid taxes when selling mutual funds?
  • To minimize your taxes when selling your mutual funds:
    • Own the mutual fund for at least a year before selling.
    • Offset any taxes on a capital gain by selling your shares when you have experienced capital losses in the same tax year.
    • Invest in mutual funds through tax-advantaged accounts.
• Are mutual funds taxed when cashed out?
  • You pay taxes on income from a mutual fund whether you cash out distributions or reinvest them in the mutual fund.

This article originally appeared on GOBankingRates.com: Mutual Funds and Taxes: How To Cut Your Bill