Mutual Fund Owners Should Avoid Unforeseen Tax on Stealthy Gains

Adam Aucoin, Tax Senior Manager
November 2014

Taxpayers who invest in mutual funds may see an increase in taxes on their 2014 income tax returns. Additional tax liability is a panic-inducing phrase for a lot of people, but planning ahead now can help ease the blow in April. This article will briefly explain the unique taxation applicable to mutual fund owners, why 2014 could create higher taxes than recent years, and what to do if you find yourself in this situation.

Mutual Fund Taxation

As many mutual fund shareholders know, the taxation of mutual funds is a little different than your traditional stock investment. With a traditional stock, you can buy and sell when you want and plan accordingly for any capital gain tax you may owe. You completely control the timing. Mutual funds differ because in addition to potential gains resulting from the owner’s sale of the shares, the fund itself can sell off some of its own holdings (stock held within the fund) with no action on your part at all. The resulting gains and/or losses are then “passed through” (reported) to the mutual fund owners, based on their ownership percentages of the fund. This is often seen on a Form 1099-DIV as a capital gain distribution. These distributions are then taxed at the applicable federal capital gains tax rate (see table below) and, for some taxpayers, subject to the federal net investment income tax of 3.8% and state tax as well.

The 2014 federal capital gains rates are as follows:

Tax Rate of Ordinary Income Capital Gain Tax Rate
10% 0%
15% 0%
25% 15%
28% 15%
33% 15%
35% 15%
39.6% 20%

One additional wrinkle is that often these distributions are directly reinvested into acquisition of new shares in the mutual fund. In that situation, a net capital gain may result in incremental tax even though no cash was received by the investor.

The Issue for 2014

2014 is gearing up as a year in which many mutual funds will have large capital gains reportable to their owners. This is due to two reasons:

  1. The stock market has recovered from the market crisis of 2008 and 2009. Many of these mutual funds have been carrying over capital losses resulting from the crisis, and in recent years these losses have been used to offset capital gains. However, the recovery absorbed many of those losses prior to and during this year, leaving mutual fund owners exposed to large gains in 2014.
  2. There has been some volatility in the market recently, and in response many fund managers will be, or have been, selling appreciated holdings at large gains and will be passing those capital gains on to the owners of the mutual funds.

What to Do

If it otherwise makes sense to do so, generating capital losses will mitigate capital gains. Short of that, the best way to deal with this is to plan ahead. If you think these capital gain distributions may apply to you it might be time to talk to both your investment and tax advisers. Both will need to know the amount of capital loss carryovers you may have available in 2014 and the amount of anticipated capital gains. Planning ahead is especially prudent in the presence of mutual funds because as previously mentioned, cash may not have been received if distributions were directly reinvested in new shares. Any resulting taxes must be paid from other means, possibly including the need to sell shares in the mutual fund itself!

The need for tax planning is not limited to mutual fund investors or applicable only to capital gains in general. However, capital gains can fluctuate from year to year, and capital loss carryovers are becoming depleted. Avoid the shock in April and consider quantifying these stealthy gains now!

If you would like to discuss these matters further, please contact your BNN professional.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

IRS CIRCULAR 230 DISCLOSURE:
Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachment) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.