So, you’ve invested in your very first mutual fund.
Congratulations! You’ve joined a large group of investors who are committed to diversifying their investment vehicles.
However, now that you’ve actually gotten into the mutual fund game, you may have some questions. While you might get a satisfactory answer from your broker or a helpful friend, but it never hurts to do a little research on your own.
A lot of first-time mutual fund investors have questions about taxes—and for good reason, too. The fact is that mutual funds are a unique type of investment vehicle that is different from stocks, bonds, and other financial products.
And that’s true of taxes, as well.
So, whether you’re already involved with your first mutual fund and you’re just curious about what to expect come tax time, or you’re wisely doing a bit of research before diving in, we’re here to help you understand how the IRS treats mutual funds.
We’re going to raise some of the most common questions we typically get regarding mutual funds and taxation from our tax debt clients—then answer them.
Questions and answers. Ready. Set. Go.
If you’re not big into investing, you may not actually be familiar with mutual funds in the first place.
Even if you are familiar with mutual funds, it’s actually worthwhile to start out with a refresher. One reason mutual funds are taxed uniquely compared to other financial products is in large part because of how they’re structured.
Mutual funds are comprised of money collected from many—hundreds or thousands—of investors to invest in a portfolio of financial securities. Each mutual fund has a portfolio of assets that are researched, structured, and maintained in order to achieve certain investment objectives. These can be mostly comprised of mostly stocks, bonds, investments within an industry, or grouped in some other way.
Additionally, mutual funds usually carry a specific risk profile—like a high-yield, riskier portfolio or a low-yield, safer portfolio. Because the money is pooled, you share some of the risk with every other investor in that mutual fund. One key benefit of mutual funds is that they can give small investors access to the type of expert money management usually only accessible to larger investors.
As with any investment, you’re hoping to make money—but there’s always the possibility you’ll lose it. There’s risk inherent to all investments, including a well-balanced and risk-averse portfolio of securities.
Just like any investment, you can expect to be taxed on the money you earn off of a mutual fund. So, if you do earn money, you’ll need to report it and pay the IRS as appropriate. No surprises there, we hope!
Just like you’d be taxed on your gains from a real estate investment or a stock purchase, you’re also taxed on the money you make via mutual funds. However, the exact rates and codes applying to how you’ll be taxed vary from mutual fund to mutual fund—and they’ll often differ from how you’d be taxed on a simple stock purchase.
How exactly you’re taxed will depend in large part on the type of securities within that mutual fund’s portfolio. Well, in your mutual fund’s investment portfolio, you may have a few high-performing stocks, or fixed-income government bonds. You may also have a few underperforming stocks. The successes and failures result in profits and losses, and any profits the mutual fund makes will usually result in a distribution for you.
Because the securities within the portfolio may vary, when you do receive the profits, you’ll be taxed according to the type of investment—either at the income tax rate, the capital gains tax rate, or sometimes, without having to pay at all.
The IRS typically taxes investment income via one of two rates: ordinary income tax and capital gains tax.
However, depending on the size of your investment to the mutual fund, the difference between the income tax rate and the capital gains tax rate can translate to thousands of dollars (or more!) in a year.
A good rule of thumb is that income you receive from investments held for less than a year are considered ordinary income, while income from investments held a year or longer is a capital gain. Capital gains carry a lower tax rate.
The reason you might want to know the difference is because you aren’t taxed based on how long your money has been with a mutual fund. You’re taxed based on how long a mutual fund has held a specific investment. So, you may have had money in a specific fund for three years without touching it. However, if the mutual fund purchased, held, and sold a security within the same year, any distributions you make will be taxed on that timeline as ordinary income—not as capital gains as though it had been held for three years.
Fortunately, you don’t need to do all that much work determining which portions of your investment are going to be considered as ordinary income or capital gains by the IRS. If a mutual fund makes distributions to you within a year (which is common), it will typically give you a full breakdown on Form 1099-DIV at the start of the next year.
Even if you’re working with a mutual fund to professionally handle your investing, we always recommend having a financial advisor or tax attorney to help you come tax season. Especially if it’s your first time, it’s easy to make mistakes that can result in an unexpected tax bill or an IRS audit.
And we’re pretty sure we can all agree that neither of those are desirable outcomes!
Whether you’re new to investing or you’re making long-term money moves, it’s always wise to build out your financial team with an eye for the future. Adding experts who care about your financial wellbeing will pay off in the long run. Literally.
A researched, diverse portfolio can help balance risk. But it’s that same thing, the reason many people like mutual funds, that makes them so tricky come tax time. However, just like every investment carries risk, every tax return carries some risk too. And in our opinion, you should never go in uninformed.
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