When you profit from your investments, you expect to hand some of your earnings over to the IRS. By planning ahead, you can make sure that the taxes you pay on your investments are as low as possible—and that you keep as much as you can of your investment returns.
What’s Taxable
The money you earn on your mutual fund investments fall into three categories: dividends, long-term and short-term capital gains. All are taxable, even mutual fund dividends and capital gains that are reinvested.
• Dividends and long-term capital gains are taxed at a maximum rate of 15%. For individuals in the two lowest income tax brackets, the rate is 5%. These rates are as of 2010 and are subject to change*.
• Short-term capital gains, as well as the income from certain types of investments, such as real estate investment trusts (REITs) are subject to ordinary income tax, which ranges from 10% to 35%.
Mutual fund investors can accrue capital gains in two ways: when a fund sells appreciated stock, it distributes capital gains to its shareholders. When a shareholder sells appreciated shares, there is a capital gain.
Year-end tax strategies
It’s a good idea to review your investments with your financial or tax professional early in the fourth quarter of each year. An advisor can help you determine whether there are tax-minimizing strategies that you can employ. For example, it may be advantageous to sell any losing positions and use the loss to offset capital gains on other investments. You can deduct up to $3,000 in losses against your adjusted gross income and carry any remaining losses forward to offset future income.
Because mutual funds often declare and distribute capital gains late in a calendar year, it often makes sense to delay the purchase of shares in a fund that you don’t already own until after the fund’s dividend is declared. If you purchase shares just before the dividend date, you will receive the dividend payment but you will also inherit a corresponding tax liability as a result of your purchase.
Year-round tax strategies
One way to potentially lower the taxes on your investments is to choose tax-exempt mutual funds for some of your fixed income allocation. The income paid by a tax-exempt fund is generally tax free, although any capital gains would be subject to taxes. Another strategy is to make the most of your contributions to tax-advantaged workplace retirement plans and individual retirement accounts (IRAs).
*The lower tax rates on dividends and capital gains is set to expire in 2011 unless extended by Congress. For accounting, or other professional advice, please consult your financial and/or tax professional.