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Tax Man: What to Know About Paying Taxes on Mutual Fund Earnings – This Yr Particularly

The good thing about equity funds is that they are managed by professionals. These people should be (better) well qualified to judge which stocks are attractive bets.

The bad thing about funds, besides the fees, is that you don't have much control over taxes. Because the fund – not you – decides which of its investments will be sold and when. If sales during the year result in total profit (most likely this year), you will receive a taxable dividend, whether you like it or not, provided you hold the shares in a taxable brokerage company account.

In fact, you can pay taxes even though your fund shares have depreciated. I'm sorry for that. This happens when the fund sells stocks that have increased in value during the fund's holding period but have decreased in value after the purchase. In the not too distant past, this little scenario came about with a vengeance and produced some poor outcomes for investors. And it could happen again. Hopefully not soon, but you never know.

Taxable distributions

Why do funds insist on taxable distributions? Because our beloved Internal Revenue Code requires them to distribute almost all of their income and profits during the year as dividends. Otherwise, they'll be hit by corporate income tax, which wouldn't help anyone but the US Treasury Department.

In the case of index funds and tax-managed (including tax-efficient) funds, the undesirable taxable distribution problem is of course less important. In most cases, index funds buy and hold, which tends to minimize taxable distributions. Tax managed funds also tend to have a buy-and-hold philosophy, and when they sell securities for a profit they seek to offset profits by selling a few losers in the same year. This approach also minimizes taxable distributions.

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Helpfully, the SEC requires mutual funds (other than money market funds and funds dedicated to tax-deferred retirement accounts only) to disclose information about both pre-tax and post-tax rates of return. Use these numbers when choosing between competing funds.

In contrast, funds that are actively turning their stock portfolios usually generate high annual distributions in a rising market, as we have before. The size of these payouts can be annoying enough, but it's even worse when a large percentage comes from short-term profits. Distributions from short-term profits are taxed at your regular federal rate, which can be up to 37%, provided there is no retroactive tax rate increase for that year. Additionally, you may owe 3.8% net investment income tax (NIIT), and you may also owe state income tax depending on where you live.

On the other hand, funds that generally buy and hold stocks for more than a year will distribute distributions, which are mainly taxed at no more than 20%, provided that there is no tax rate increase, despite the 3.8% NIIT and the state Income tax increases the tax can bite considerably.

The tax plan proposed by Biden would raise the highest federal income tax rate on short-term net capital gains

Beginning in 2022, Biden's proposed tax plan would raise the highest federal income tax rate on individually recognized net short-term capital gains, including those from mutual fund distributions, back to 39.6%, the highest rate that was in effect before the Cuts and Jobs Act lowered it currently 37%. This proposed rate increase would affect singles with taxable incomes over $ 452,700, married couples enrolled together with taxable incomes over $ 509,300, and householders with taxable incomes over $ 481,000. After pinning the NIIT of 3.8%, the maximum effective rate would be 43.4% (39.6% + 3.8%), compared to the current maximum effective rate of 40.8% (37% + 3.8%) ).

Biden's proposed tax plan would also retroactively increase the federal maximum rate for long-term net capital gains to 39.6% for gains recognized after April this year, though the exact timing is still unclear. After adding the NIIT of 3.8%, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of "only" 23.8% (20% + 3, 8th%).

The proposed tax rate increase applies only to taxpayers with an Adjusted Gross Income (AGI) above $ 1 million or above $ 500,000 when using the married separate filing status. You will only be subject to the higher maximum rate if your AGI exceeds the applicable threshold. For example, a married couple filing together with an AGI of 1.2 million. Will this proposed retrospective nearly doubling the maximum effective interest rate on long-term profits enforce a narrowly divided Congress? We will see.

When choosing between competing funds, after-tax returns are what count

Assuming you're not one of those looking to pay higher taxes and investing through a taxable brokerage firm account, you should really look at the type of after-tax income different funds have made. Use these numbers when choosing between competing funds. However, if you use a tax-privileged account (traditional or Roth IRA, 401 (k), Keogh, SEP, variable annuity, etc) to hold mutual fund investments, you can focus strictly on each fund's pre-tax returns and ignore all of that tax stuff .

Helpfully, the SEC requires mutual funds (other than money market funds and funds dedicated to tax-deferred retirement accounts only) to disclose information about both pre-tax and post-tax rates of return. When calculating the after-tax income, it is assumed that the short-term profits distributed by the fund are taxed at the highest ordinary federal income rate (currently 37%). It is assumed that long-term capital gains distributions and long-term profits from the sale of fund units are initially taxed at 20%. The same methodology must be used to calculate all post-tax return information presented in advertisements and sales literature. This SEC rule makes it easier for investors to make informed comparisons of fund performance data, but you need to read quite a bit to benefit from it.

Stay tuned for the rest of the mutual fund story

With those basics behind us, please stay tuned for the second part of this two-part series coming next week. I'm going to cover some important details about the treatment of mutual fund investments under federal income tax rules.

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