In last week’s Tax Guy column, I pointed out that a big negative about equity mutual funds is that you don’t have much control over taxes. The fund decides which investments to sell and when. If the fund sells investments that have increased in value since their acquisition, the resulting gains will be paid to you in the form of dividend distributions.
If you hold your fund units in a taxable brokerage firm account, these distributions will be taxable. The tax rate you will pay depends on your income level, whether the gains are short-term or long-term and whether the proposed tax rate increases become reality.
Biden’s proposed tax rate increases
Beginning in 2022, Biden’s proposed tax plan would raise the highest federal tax rate on short-term net capital gains recognized by individuals, including those from mutual fund distributions, to 39. 6%, the maximum rate in force before the tax The law on cuts and employment has lowered it to 37% currently.
This proposed rate increase would affect singles with taxable income over $ 452,700, married couples filing jointly with taxable income over $ 509,300 and heads of households with taxable income over $ 481,000. After adding the net investment income tax (NIIT) of 3.8%, the maximum effective rate would be 43.4% (39.6% + 3.8%) against the current maximum rate of 40, 8% (37% + 3.8%).
Biden’s proposed tax plan would also increase the maximum federal rate on long-term net capital gains, including those from mutual fund distributions, to 39.6% for gains recognized after April of this year, although that the exact timeline is still unclear. After setting the NIIT 3.8%, the maximum effective rate would be 43.4% (39.6% + 3.8%) against the current maximum effective rate of “only” 23.8% (20% + 3.8%).
The proposed rate hike would only hit taxpayers with Adjusted Gross Income (AGI) greater than $ 1 million, or greater than $ 500,000 if using the separate marriage declaration status, so you might not be affected. If so, you only pay the highest maximum rate to the extent that your AGI exceeds the applicable threshold. For example, a married couple jointly filing with an AGI of $ 1.2 million, including a long-term net capital gain of $ 300,000, would pay the maximum rate of 39.6% / 43.4% only on the last $ 200,000 of long-term net capital gain. Will this proposed retroactive quasi-doubling of the maximum effective federal rate on long-term earnings pass through Congress? We will see.
But there is more to consider beyond current and future tax rates. Here is the rest of the story on mutual funds and taxes.
Who made a sale? Not me!
As with common stocks, you can make outright sales of mutual fund stocks. When making a outright sale, you are (hopefully) well aware that you need to calculate your tax gain or loss amount. The tricky part is that mutual fund companies allow investors to make other transactions that are also treated as taxable sales. The added convenience of being able to do these transactions is great, as long as you understand the tax ramifications. Here are two common transactions that can lead to unexpected sales of mutual fund stocks.
Your fund company allows you to issue checks on your account with cash from the liquidation of part of your investment in fund units. When you take advantage of this convenient arrangement, you have made a sale and you need to calculate the resulting capital gain or loss for tax purposes.
You transfer your investment from one fund in a family of mutual funds (Fidelity, T. Rowe Price, etc.) to another fund in the same family. Again, this is a taxable sale.
The ex-dividend factor
Equity UCIs generally distribute all (or almost all) of their annual capital gains to avoid having to pay corporation tax on these capital gains. This can result in large distributions of taxable dividends in the fourth quarter. Based on this year’s stock market results so far, some of this year’s distributions could be unusually large. And they could be paid as early as November, which will be there before you know it.
If you own shares on the dividend record date of the mutual fund, you will receive the next dividend. The ex-dividend date is generally the day after the registration date. If you buy on or after the ex-dividend date, you will not receive the upcoming dividend. The actual dividend payment date is usually a few days after the ex-dividend date. For example, a fund might expect its fourth quarter 2021 dividend to be paid to owners of record on 11/29/21. Thus, the dividend registration date is 29/11. The ex-dividend date will likely be 11/30. The actual dividend payment date could be 3/12.
If you are considering buying from a fund
If you buy into a mutual fund shortly before the ex-dividend date, you will receive the upcoming dividend distribution, but you will also receive the accompanying tax bill. So you end up paying taxes on any gains made by the fund even before you become a shareholder. Not good.
A portion of the future distribution may consist of long-term capital gains and eligible dividends from shares held by the fund. The federal tax rate on this portion of the distribution can go up to 20%, plus another 3.8% for the NIIT, assuming there is no retroactive increase in the tax rate. Part of the future distribution may consist of short-term capital gains and interest. The federal tax rate on this portion can be up to 37%, plus 3.8% for the NIIT, assuming there are no retroactive tax rate increases. you may also owe state income tax, depending on where you live.
Example: The ZOOM fund declares a fourth quarter dividend of $ 5 per share to owners of record as of 11/29/21. Thus, the date of registration of the dividend is 29/11. The ex-dividend date is 11/30. The dividend will be paid on 12/3.
On November 25, you decide to invest $ 40,000 from your taxable brokerage account to buy 1,000 shares of ZOOM at $ 40 per share. Since you buy before the ex-dividend date of 11/30, you will receive the next dividend of $ 5 per share (total of $ 5,000). All other things being equal, the price per share of ZOOM will drop by $ 5 on 11/30 (the ex-dividend date) to reflect the fact that new shareholders will not receive the upcoming dividend and to reflect the reduction in the dividend. the fund’s net asset value (NAV) as a result of the payment of this dividend.
So, assuming there is no other influence on ZOOM’s price, the shares will sell for $ 35 on 11/30. However, you paid $ 40 for your shares and you have to pay tax on the next dividend of $ 5,000. If you had waited a few days and bought on the ex-dividend date of 11/30 or after, you could have avoided the dividend and related tax and bought more shares with the same $ 40,000 investment. Whoops.
To avoid the tax problem illustrated in the previous example, you should have contacted the fund to find out the next ex-dividend date and the expected dividend amount. Then you could have bought from the ex-dividend date.
If you plan to sell fund units
If you plan to sell popular mutual fund units that you have owned for more than a year, the resulting profit will be long-term appreciation. As such, the maximum federal income rate will be “only” 20%, assuming there will be no retroactive tax rate hike for that year. You may also owe 3.8% NIIT as well as state income tax depending on where you live.
If you sell before the fund’s ex-dividend date, you will not receive the upcoming dividend distribution and your total profit will be a less taxed long-term capital gain, as long as you have held the shares for more than a year.
On the other hand, if you sell on or after the ex-dividend date, you will receive the next dividend distribution. Part of this distribution may consist of short-term, heavily taxed capital gains. If this is the case, the tax impact will be even higher.
The bottom line
As you can see, mutual fund distributions can have significant tax implications, and this is especially true for fourth quarter distributions. This year, the issue will likely be even more important, as funds that have benefited from the strength of the stock market are likely to make above-normal distributions.
Finally, remember that none of these tax issues matter for mutual fund stocks held in tax-advantaged accounts like traditional IRAs, Roth IRAs, SEP accounts, and 401 (k) accounts ( k). With these accounts, you only owe taxes when you make withdrawals. Until then, the gains and losses that accumulate in your account have no tax impact.