Mutual Funds and Long-Term Capital Gains

Learning to navigate mutual funds and long-term capital gains can be a significant challenge. Before putting your capital into any investment vehicle, you should understand the tax ramifications for your particular circumstances. Particularly at a time when most experts agree that higher taxes are coming, being prepared to defend your money is a matter of knowledge. Finally, as an ever-increasing number of options–such as exchange-traded funds (ETFs)–become available, being well positioned has never been more important.

The Types of Long-Term Gains

Mutual funds are particularly hard to understand because they can pay multiple types of distributions. You may receive ordinary dividends, qualified dividends, capital gains distributions or tax-free interest, depending on the specific fund in which you are invested. Ordinary dividends are often taxed as ordinary income, although they are really short-term gains. This distinction means that you can use these gains as offsets against short-term losses to net them out. Depending on the length of time that the mutual fund held the securities that generated the gain, your dividend may be classified as a qualified dividend or as a capital gains distribution. In either case, you will pay a lower tax rate on this money. The fourth kind of distribution occurs in funds that invest in government or other tax-exempt securities like municipal bonds. In each of these cases, the gain or loss is handled a bit differently. Understanding each will allow you to plan your overall tax strategy.

How Gains Are Generated

In some cases, a mutual fund may create gains as a result of a successful investment's reaching its profit objective and being closed. In other cases, however, these gains are created as a function of how shares are created and destroyed. Many funds keep the majority of their capital invested so as to earn the best return possible for their investors. The problem that this creates is that if you redeem a large block of shares in a given day, the fund must sell securities to raise the cash needed to make the distribution. As shares are created and destroyed throughout the course of the year, securities are bought and sold to keep the fund in line with its investment objective. This creates tax consequences that may not be the intention of the fund but that are the responsibility of investors regardless. If you own a mutual fund, part of the expense ratio will be used to pay taxes.

Alternatives to Mutual Funds

The mechanics of ETF shares are very different from those of mutual funds. As a result, ETF shares are treated by the IRS like ordinary stock shares. This gives you a heightened level of control over the tax treatment that your shares receive. If you hold the shares for the long-term, you will pay capital gains only when the shares are sold. Dividends will be treated as regular stock dividends, but the overall capital gain versus ordinary income treatment is ultimately the result of how long you decide to keep the shares in your portfolio–the creation and redemption of shares does not result in a taxable event.

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