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TAX TALK: Hidden Pitfalls in Mutual Fund Investing

Posted by Hal Zemel, CPA, J.D., LL.M. on Jul 11, 2016 7:49:06 AM
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Mutual funds provide an easy way to diversify your portfolio, which is one reason why they are a common investment in retirement plans such as IRAs and 401(k)s. However, if you invest in mutual funds in your taxable accounts, or are considering such investments, beware of these three hidden tax costs:

  1. Low tax efficiency. Mutual funds with high turnover rates can create two tax related issues. First, capital gains realized during the year by the mutual fund are passed out to the investors as a capital gains distribution at the end of the year and create current taxable income to the investor. Second, if the mutual fund realizes short term capital gains, the income is taxed at ordinary-income tax rates. Choosing mutual funds that are rated highly in tax efficiency should provide you with less current taxable income and preferential capital gain rates for current income that you do incur.
  2. Tracking basis. Many mutual fund investors take advantage of dividend reinvestment plans (DRIPs). The earnings (dividends and capital gains distribution) on the mutual funds are typically reinvested and increase the investor’s tax basis. Unless you keep track of these increases to your basis, you may report more capital gain than required when you sell the mutual fund. (However, since 2012, brokerage firms have been required to track — and report to the IRS — your cost basis in mutual funds acquired during the tax year.)
  3. Timing issues. Many mutual fund investors set-up automatic investment plans (AIP), whereby they purchase a specific dollar amount of a mutual fund at regular intervals, i.e. every week, bi-weekly, monthly, etc. However, for mutual investors making a one-time mutual fund investment, you may want to wait until after the mutual fund declares its capital gains distribution for the year. If you own a mutual fund on the distribution’s record date, you’ll be taxed on the full year’s capital gains distribution even if it includes significant gains realized by the mutual fund prior to the date you owned the fund. Also, you will be taxed on those gains in the current year — even if you reinvest the distribution.

If your mutual fund investments aren’t limited to your tax-advantaged retirement accounts, watch out for these hazards. And contact me at or your Berdon advisor — we can help you safely navigate them to keep your tax liability to a minimum.

Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.

Topics: TAX TALK

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