Proper planning reduces confusion and minimizes taxes.
Following the phenomenal economic growth of the 1980s, investor interest in mutual funds has continued into the 1990s. Mutual funds have made it easier for small investors to have access to capital markets-- investors who otherwise lack the funds either to diversify their portfolios sufficiently or to justify hiring professionals to manage them. Because of the importance of mutual funds as an investment vehicle for both middle- and upper-income individuals, CPAs must be able to provide clients with tax strategies for buying and selling.
This article reviews the rules mutual fund investors must know to minimize taxation and maximize wealth accumulation.
TAX TREATMENT OF SHAREHOLDER DISTRIBUTIONS
Mutual fund shareholders may receive one or more of the following distributions:
* Ordinary dividends.
* Capital gains dividends.
* Exempt-interest dividends.
* Return-of-capital (nontaxable) distributions. A foreign tax credit will be passed through to shareholders if more than 50% of the fund's assets consists of stocks or securities in foreign corporations.
Distributions from short-term capital gains income are classified and taxed as an ordinary dividend. A capital gains dividend is classified and taxed as a long-term capital gain. Capital losses realized by the fund are not passed through to shareholders but are offset against capital gains. Unused losses are carried forward for up to eight years to be offset against subsequent gains.
All mutual funds charge annual management fees that, along with other annual investment expenses such as shareholder servicing costs, are deducted from dividend distributions. If investment expenses exceed net investment income, no distribution is required. If a fund chooses to retain capital gains (most do not), the fund may nevertheless elect to have the gains taxed as if they had been distributed and subsequently reinvested. The fund pays the taxes on the gains and passes them through to shareholders as refundable credits. Shareholders are entitled to increase their cost bases in the fund by the amounts of the deemed dividend distributions, less the credit.
Because fund distributions represent asset transfers from the fund to shareholders, the per share net asset value decreases by the exact amount of the per share distribution. A shareholder generally reports dividends in the taxable year they are received. An exception, however, is made for dividends declared in October, November or December and payable to shareholders of record during these months. If dividends actually are paid by February 1 of the following year, they are deemed to have been paid the previous year.
Mutual funds typically offer shareholders the opportunity to reinvest distributions to purchase additional shares instead of receiving them in cash. Regardless of whether additional shares are purchased or a cash payment is made, the distribution is taxable to the shareholder.
TAX STRATEGIES FOR ACQUIRING MUTUAL FUND SHARES
Mutual fund investors can use a number of planning strategies to minimize their income tax liabilities.
Avoid buying into tax liabilities. An investor who buys shares in a mutual fund also purchases part of the fund's accumulated untaxed dividends and capital gains. Consequently, when new shareholders receive distributions of previously accrued dividends and gains, they are in effect receiving a return of capital. Nevertheless, they are immediately taxed on the distribution. Rather than creating a permanent increase in taxable income the increase will be remedied if and when a shareholder redeems shares in the fund. They will have a smaller gain (or greater loss) equal to the amount of additional income from purchasing the fund before the distribution date instead of on the ex-distribution date---the date a purchasing shareholder is no longer entitled to the distribution. …