Posts Tagged ‘mutual fund investments’

Costs Associated with Investing in Mutual Funds

June 2nd, 2011

If you’ve invested in mutual funds, you should know that taxes can affect your investment, sometimes significantly reducing your net returns. To completely avoid federal taxes, consider investments such as tax free municipal bonds. Also be aware that some mutual fund investments are more tax efficient than others. Below is some basic information regarding mutual fund fees, expenses and income taxation, check with your professional tax preparer regarding your specific tax situation.

What other costs are associated with mutual funds?

In addition to taxes, mutual fund fees and ongoing fund expenses related to holding mutual funds affect your net returns. For instance, when you sell, buy, and exchange shares, you will likely pay sales loads and transaction fees. Additionally, as a mutual fund holder you must pay ongoing expenses, i.e. management fees and 12b-1 fees.

When you’re considering purchasing a mutual fund, be sure to consult the fee table located at the front of its prospectus. This table compares the costs of different funds. And be aware that just because high fees are associated with a fund doesn’t necessarily mean that it’s a high-performing investment product.

Nontaxable capital returns
You can receive a return on a mutual fund without having to pay taxes on it. Usually, this happens when the return recovers some or all of your cost basis in the fund. Because they’re not strictly earnings, these returns are tax-free. You must, however, report them on your tax return.

Taxable dividend income
Many mutual funds pay dividends on a yearly, monthly, or quarterly basis to shareholders on a pro-rata basis. These dividends must be reported on your tax return for the year they were distributed.

Mutual fund dividends earned by individual shareholders often, but not always, qualify for taxation at capital gains rates. For instance, corporate stock dividends that a mutual fund receives and passes to shareholders usually qualifies for taxation at capital gains rates. If, however, mutual fund dividends are the result of other some other type of earning, such as interest, they’re taxed like ordinary income. Furthermore, special holding period requirements often must be met in order for dividends to qualify for long-term capital gain tax treatment.

Short-term capital gains
For tax purposes, short-term capital gain distributions are usually treated like dividends.

Long-term capital gains
Fund shareholders receive long-term capital gain distributions on a pro-rata basis. They must report these earning on their tax returns as long-term capital gains no matter how long they have held them.

Selling shares
When you sell shares in a mutual fund, usually you must pay tax on any capital gains earned. The taxable amount is ordinarily equal to the difference between the sale price and the original share purchase price. The tax owed on a gain depends on the rate at which the gain is taxed, which depends on how long you held the shares before selling them. In general, if you hold shares over a year before you sell them, any gain realized is considered long-term capital gain. On the other hand, if you sell after less than a year, any gains you earn will be considered short-term gain and taxed accordingly.

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