Understanding Mutual Fund Taxation.

AuthorSCHNEPPER, JEFF A.
PositionBrief Article

I RECENTLY HAD DINNER with Rep. Jim Saxton (R.-N.J.) where the topic of discussion was professions--specifically, who had the oldest? The physician on my right insisted that it was his. Wasn't the removal of a rib from Adam to create Eve a surgical procedure? I countered that, in the beginning, God created order out of chaos. I'm a tax planner, so isn't that my job? Thus, I have the oldest profession. My victory was short-lived. Saxton looked up at us, smiled, and asked, "Who do you think created the chaos?"

When we tall about mutual fund taxation, we're talking about chaos. There's inside gain, outside gain, and enough basis complications and convolutions to confuse a convention of wizards. Let's see if I can clarify some of this confusion.

There are two levels of taxation with respect to mutual funds. The first is the "inside gain"--that earned by the fund itself through the operations of the fund. At the end of January each year, your mutual funds send you Form 1099 showing your portion of their inside gain--their dividends, interest, and short- and long-term gains. You report those gains on your 1040, Schedules B and D, and pay tax at your individual rate.

The amount and timing of these gains is pretty much out of your control. Because mutual funds are pass-through entities, they are not taxed on their gains. Those gains are proportionately passed through to you as an investor in the funds. That is why it's important never to invest in a mutual fund just before the date of record--the day the fund will look at its record of owners and allocate to them all the gains and losses from the year's operations.

When you buy into a mutual fund, you are buying into a portfolio of securities, many of which may have been bought many years ago. If the fund manager has been successful, these securities are pregnant with potential capital gains. If you buy into the fund on Dec. 1 and the date of record is Dec. 15, you are going to be taxed on your share of the fund's full year's gains even though you just held the fund for two weeks. Not only are you going to be taxed on those gains, but when you bought the shares, you actually paid for those gains in the price of the shares you purchased.

An investor may really have a problem here. A successful fund will have securities that have incurred significant appreciation. A fund that bought Microsoft years ago would have shown an incredible past earning record as a result of the company's past appreciation...

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