Chapter 39 Mutual funds ey.com/EYTaxGuide
A mutual fund is an investment created by “pooling” money from many investors and investing the money in stocks, bonds, short-term money market instruments, or other securities. A mutual fund will have a fund manager that buys and sells stocks, bonds, and other securities according to the style dictated by the fund’s investment objectives. Reviewing a mutual fund’s investment objective is an important consideration for any investor as the thousands of different mutual funds have different features, risks, and rewards. Aggressive growth funds, for example, are characterized by high risk and high potential return. These funds typically seek long-term capital appreciation and do not produce significant interest income or dividends. The objectives of balanced funds, on the other hand, are to conserve an investor’s initial principal, pay current income through dividends, and promote the long-term growth of both principal and income. While aggressive growth funds generally invest only in stocks, balanced funds typically invest in both bonds and stocks. There are many other kinds of mutual funds—growth and income funds, bond funds, sector funds, index funds, and the like—all with different investing objectives and different strategies to achieve them. A general rule to keep in mind: The higher the potential reward from your investment, the greater risk of potential loss.
This chapter explains how differing distributions you may receive from a mutual fund are taxed, as well as the different methods by which you may calculate your gain or loss when you sell your mutual fund shares. It also discusses some of the expenses you may incur when investing in mutual funds.
Avoiding unexpected taxable income from a mutual fund. If you buy mutual fund shares right before a dividend distribution, you may be buying a tax liability. The share price you pay reflects this dividend right. For example, say that you buy 1,000 mutual fund shares for $20 a share shortly before the fund declares and pays a dividend of $4 per share. As a result of the dividend, the price per share will drop to $16. You will have to include the $4,000 ($4 per share × 1,000) dividend in your income even though there has been no increase in the overall value of your investment. If the investment had been delayed until after the dividend, the same $20,000 investment would have purchased 1,250 shares (at $16 per share) and this problem would have been avoided.
Tax-managed and index funds. A “tax-managed” mutual fund is a type of mutual fund where the fund’s managers are required to employ a series of strategies designed to keep the investors’ tax consequences to a minimum. Most large fund companies have tax-managed funds, and taxpayers often own these types of mutual funds in a taxable account (versus a tax-deferred account like a 401(k) or IRA). In addition to tax-managed funds, you might want to also consider stock index funds within a taxable account, which invest in the stocks making up a particular market index; for example, the Standard & Poor’s index of 500 large companies. Since these funds stay invested only in the stocks making up the particular index, there are relatively few sales of stock from the portfolio and only a small amount of realized capital gain.
A mutual fund is a regulated investment company generally created by “pooling” funds of investors to allow them to take advantage of a diversity of investments and professional management. The advantages that investment companies can offer you are numerous, including:
Professional investment management of assets at a relatively low cost Ownership in a diversified portfolioPotentially lower commissions, because the investment company buys and sells in large blocks Prospectuses and reports of various periodicals to assist people in readily accessing information needed to perform fund comparisons Other special services, such as dividend reinvestment plans, periodic withdrawal and investment plans, the ability to switch between funds by telephone or over the Internet, and in some cases, check-writing privileges Mutual funds are classified according to their investment objectives. The following is a summary of common types of funds categorized by their investment objective.
Aggressive growth funds. These funds are characterized by high risk and high potential return. They typically seek capital appreciation and do not produce significant interest income or dividends.
Growth funds. Growth funds aim to achieve an increase in the value of their investments over the long term (capital gains) rather than paying dividends.
Growth and income funds. Also called “equity-income” and “total return” funds, these funds aim to balance the objectives of long-term growth and current income.
Balanced funds. These funds have three objectives: to conserve investors’ initial principal, to pay high current income through dividends and interest, and to promote long-term growth of both principal and income. Balanced funds invest in both bonds and stocks.
Bond funds. Bond mutual funds invest primarily in bonds. Some funds may concentrate on short-term bonds, others on intermediate-term bonds, and still others on long-term bonds.
Sector funds. Sector funds invest in one industry, such as biotechnology or retail, and therefore do not offer the diversity you generally receive from a diversified growth mutual fund, which might invest a portion of the fund assets in a variety of sectors.
Index funds. Index mutual funds re-create a particular market index (e.g., the S&P 500). The holdings and the return should mirror that of the index.
Target date retirement funds. These funds invest in both stocks and bonds for specific long-term periods that you can match with your anticipated retirement date. Also referred to as life-cycle funds, they automatically rebalance their investment portfolios to a more conservative asset allocation as the participant approaches their retirement target date.
Money market funds. This is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risk compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a “money market deposit account” at a bank, money market funds are not federally insured.
In addition to categorizing investment companies by their investment objectives, investment companies are classified by three types of capital structures:
Closed-end funds Unit investment trusts Open-end funds Closed-end funds. Closed-end investment companies have a set capital structure with a specified number of shares. For this reason, investors must generally purchase existing shares of closed-end funds from current stockholders. Investors who wish to liquidate their position in closed-end investment companies must sell their shares to other investors. Shares in closed-end funds are therefore traded on the open market just like the stock of publicly held corporations. As a result, closed-end funds have an additional risk that isn’t present in open-end funds (discussed below)—their price does not necessarily equal their net asset value. Therefore, there is a risk that the fund’s shares could sell for less than the value of the underlying investments. However, closed-end funds that are purchased at a discount from the value of the underlying investments can produce an opportunity for greater return.
Unit investment trusts. Unit investment trusts are a variation of closed-end funds. Unit investment trusts typically invest in a fixed portfolio of bonds that are held until maturity rather than managed and traded, as is the case with bond mutual funds. As an investor you purchase units that represent an ownership in the trust assets. Because the bonds are not actively traded, the annual fees charged for unit trusts may be lower than those charged by bond mutual funds. The unit trust collects the interest income and repayment of principal of the bonds held in the portfolio and distributes these funds to the unit holders. Unit investment trusts can provide you with a portfolio of bonds that have different maturity dates and an average holding period that meets your objectives. Cash flow is relatively predictable, because the intention is to hold the bonds until maturity.
Open-end funds. Commonly referred to as mutual funds, open-end funds differ from closed-end funds in that they do not have a fixed number of shares to issue. Instead, the number of shares outstanding varies as investors purchase and redeem them directly from the open-end investment company. An investor who wants a position in a particular mutual fund purchases the shares from the fund either through a brokerage firm or by contacting the fund company directly. Conversely, mutual fund shareholders who want to liquidate their position sell their shares back to the company. The value of a share in a mutual fund is determined by the net asset value (NAV). Funds compute NAV by dividing the value of the fund’s total net assets by the number of shares outstanding.
The costs associated with open-end fund shares resemble those for closed-end funds. Like closed-end funds, open-end funds bear the trading costs and investment management fees of the investment company. However, mutual fund investors may or may not be subject to a sales charge referred to as a “load.”
Open-end mutual funds are classified by their type of load charge. These are:
No-load funds 12b-1 funds Load funds No-load funds. No-load funds don’t impose a sales charge on their investors. Purchases and sales of shares in a no-load fund are made at the fund’s NAV per share. Consequently, every dollar invested gets allocated to the fund for investment rather than having a portion permanently kept back to cover sales charges.
12b-1 funds. 12b-1 funds are a variation on no-load funds. While every dollar paid into the fund is committed to investment, the 12b-1 fund shareholders indirectly pay an annual fee to cover the fund’s sales and marketing costs. This 12b-1 fee typically ranges from 0.1% to the maximum 1% of total fund net assets.
Note: The 12b-1 fee is assessed every year (instead of only once); thus, the longer you hold your 12b-1 fund shares, the greater the sales charge you will bear.
Load funds. Load funds charge the shareholder a direct commission at the time of purchase and/or when the shares are redeemed and may also assess ongoing 12b-1 fees. “Front-end loads” are charged to the investor at the time of purchase and can be as high as 8.5% of the gross amount invested. On the other hand, some load funds charge their shareholders the load at the time their shares are redeemed. This cost will be either a “back-end load” or a “redemption fee.” A back-end load is based on the lesser of the initial cost or final value of the shares redeemed and may disappear after a certain number of years. A redemption fee is similar to a back-end load, but is based on the value of the shares you choose to redeem rather than your initial investment. It typically applies if the investor sells within a very short period of time (usually 30 to 90 days). The purpose of such fees is to discourage shareholders from short-term trading of fund shares.
All fees, loads, and charges reduce your investment return. Therefore, you should consider not only a fund’s return, but all of the expenses that affect this return.
Many stock mutual funds invest in foreign stocks. They are divided into the following categories:
Global or world funds. These funds invest anywhere in the world, including the United States.International or foreign funds. Such funds invest anywhere in the world except the United States.Emerging markets funds. These funds invest in financial markets of a single developing country or a group of developing countries. A developing country is categorized by the prospect of economic growth and potential vulnerability to economic and political instability. These funds are sought by investors for the prospect of higher returns but generally carry additional risk.Regional funds. These invest in specific geographic areas, such as Europe, Latin America, or the Pacific Rim.Country funds. Funds of this sort invest entirely in a specific country. For the most part, single country funds are closed-end mutual funds that typically trade on either the New York Stock Exchange or the American Stock Exchange.International index funds. These are mutual funds that parallel the concept of a domestic equity index fund. They are designed and operated so that their portfolios mirror the composition of the market index after which the funds are named. In addition to foreign stock funds, numerous foreign bond funds are available for investment. Because economic conditions differ from country to country, interest rates vary as well. At any given time, you can usually find several countries with interest rates higher than those in the United States. There is a downside to consider, though. Overseas interest rates may be more attractive, but language barriers, differing regulations, and illiquid markets all increase the challenge of foreign investments. Fluctuating currency values, although a potential advantage, can work against you if the currency of your foreign investment loses value relative to the U.S. dollar.
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550 Investment Income and Expenses
Beginning with the 2011 tax year, the IRS requires all brokers to report adjusted cost basis in addition to gross proceeds for covered securities and also to report whether the related gain or loss is long-term or short-term. Regulated investment company (RIC) and dividend reinvestment plan (DRP) shares that are purchased or acquired after 2011 are classified as covered securities. See chapter 16 Reporting gains and losses , for further information on covered securities and the three-year implementation period for the these basis-reporting regulations.
For RIC and DRP shares, brokers must report the adjusted cost basis in accordance with their default method unless a taxpayer notifies the financial institution in writing to use a different method.
Throughout this chapter, the term mutual fund is used in place of RIC when discussing the new basis reporting rules. However, a broker will determine if a mutual fund should be classified as an RIC and therefore be subject to the basis reporting requirements.
A distribution you receive from a mutual fund may be an ordinary dividend, a qualified dividend, a capital gain distribution, an exempt-interest dividend, or a nondividend distribution. The fund will send you a Form 1099-DIV or similar statement telling you the kind of distribution you received. This section discusses the tax treatment of each kind of distribution, describes how to treat reinvested distributions, and explains how to report distributions on your return.
As part of the Affordable Care Act, the Net Investment Income Tax (NIIT) on unearned income of individuals took effect for tax years beginning in 2013 and thereafter. For individuals, the NIIT is 3.8% of the lesser of: (1) “net investment income” or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly; $125,000 if married filing separately). Net investment income subject to the tax is defined as investment income reduced by allocable deductions. Investment income includes dividends, capital gains distributions, and both short-term and long-term capital gains, as well as other items of income. The NIIT is payable regardless of whether you otherwise pay any regular income tax or are subject to alternative minimum tax on your income.
How mutual funds are taxed. Which mutual fund or funds you choose will depend largely on your own investment objectives. One factor you should definitely consider is how your mutual fund investment will be taxed. Generally, a mutual fund is a conduit for tax purposes—that is, the fund does not ordinarily pay income taxes, but its shareholders do. Interest, dividends, gains, and losses are generally passed through to shareholders in a fund in the form of dividends and capital gains distributions. As a shareholder, you are liable for any taxes due on these distributions. Consequently, it can matter enormously how those gains and losses are taxed.
Dividends declared during the last quarter of one year but not paid until the next year. Often, a mutual fund will declare a dividend in October, November, or December of one year but not pay it until January of the following year. Nevertheless, you are treated as having received the dividend in the year in which it was declared.
Example. A fund declares a dividend in December 2014 payable to shareholders owning stock on that date. This is known as the record date. The dividend is not paid until January 2015. You are treated as having received the dividend on December 31, 2014.
Timing your purchase of a mutual fund. You should pay close attention to the timing of your purchase of a mutual fund. For example, if you invest in a fund near the end of the year and the fund shortly thereafter makes a year-end distribution, you will have to pay tax on the distribution even though from your point of view you are simply getting back the capital you just invested in the fund. In effect, all you’ve done is “bought” taxable income that the fund earned earlier in the year but had not yet paid out to shareholders. Typically, the fund’s share price drops by the amount of the distribution. Your cost basis in the mutual fund, however, will be the pre-distribution price you paid for the shares.
There is one consolation. Your higher basis will reduce any capital gain on a later sale. Moreover, if you sell the fund at a loss, it will produce a capital loss. If you want to limit your current tax liability and lower your basis in the shares, you should delay your purchase of fund shares until after the record date for the distribution. Usually, a fund can tell you when distributions, if any, for the year are expected. Alternatively, you can consult investment publications, such as Morningstar Mutual Funds , which indicate distribution dates for the previous year.
Example. ABC Fund declares and distributes a $1 dividend on November 25, 2014. If you purchased 1,000 shares at $10 per share on November 24, 2014, you will have to report $1,000 of income for 2014. If instead you bought the shares on December 1, 2014, after the record date, you will pay $9 per share and have no taxable income to report in 2014. Of course, for the shares bought on November 25, your basis would be $10 per share instead of $9.
Year-end selling. If you are thinking of selling shares in a mutual fund, particularly near the end of the year when many funds pay dividends, you should consider redeeming your shares before any upcoming dividend is paid by the fund. If your shares are worth more than you paid and are held for more than one year, it might be to your advantage to sell the shares before a dividend is declared to take advantage of the 20% maximum long-term capital gains tax rate. If you wait until after the dividend is declared to sell, there is the possibility that some portion of the dividend may not be qualified dividend income and therefore be taxed at the higher ordinary income tax rates. Additionally, if your shares are worth more than you paid and if you have capital losses available in the current year, it might be to your advantage to sell the shares before a dividend is declared. The gain on the sale of the mutual fund shares, unlike the dividend income, can be offset by the capital losses. However, if your shares are worth less than what you paid for them, you can minimize your capital losses by selling the shares before the dividend is paid. Remember, the net asset value per share of the fund (that is, the amount you would receive on the redemption of your shares) decreases by the amount of the dividend.
Community property states. If you and your spouse live in a community property state and receive a distribution that is community income, one-half of the distribution is considered received by each of you. If you file separate returns, each of you must generally report one-half of any taxable distribution. For more information about community property, see Publication 555, Community Property .
If the distribution is not considered community income under state law and you and your spouse file separate returns, each of you must report your separate taxable distributions.
Share certificate in two or more names. If two or more persons, such as you and your spouse, hold shares as joint tenants, tenants by the entirety, or tenants in common, distributions on those shares are considered received by each of you to the extent provided by local law.
Tax-exempt mutual fund. Distributions from a tax-exempt mutual fund (one that invests primarily in tax-exempt securities) may consist of ordinary dividends, capital gain distributions, undistributed capital gains, or return of capital like any other mutual fund. These distributions generally are treated the same as distributions from a regular mutual fund. Distributions designated as exempt-interest dividends are not taxable. (See Exempt-Interest Dividends
All other distributions generally follow the same rules as a regular mutual fund. Regardless of what type of mutual fund you have (whether regular or tax-exempt), when you dispose of your shares (sell, exchange, or redeem), you usually will have a taxable gain or a deductible loss to report.
For more information on figuring taxable gains and losses see Sales, Exchanges, and Redemptions chapter 16 Reporting Gains and Losses , for further information.
Ordinary (taxable) dividends are the most common type of distribution from a mutual fund. They are paid out of earnings and profits and are ordinary income to you. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the mutual fund tells you otherwise. Ordinary dividends will be reported in box 1a of the Form 1099-DIV or on a similar statement you receive from the mutual fund.
Dividend distributions from a mutual fund, such as dividends earned from the fund’s investment securities, are generally treated as a net short-term capital gain for purposes of applying the capital gain tax rates for both the regular tax and the alternative minimum tax. In order to be eligible for the lower capital gain (versus ordinary) income tax rate, the mutual fund must hold the underlying stock for a specified time period. Each year, the mutual fund will be required to report to each shareholder the amount of dividends that qualify for the favorable capital gain and/or ordinary income tax treatment.
Qualified dividends are ordinary dividends subject to the same 0%, 15%, or 20% maximum tax rate that applies to net capital gain. They will be shown in box 1b of Form 1099-DIV you receive.
Qualified dividends are subject to the 20% rate if your regular marginal tax rate is 39.6%. If your regular marginal tax rate is 25%, 28%, or 33%, then the tax rate on qualified dividends is 15%. If your regular marginal tax rate is either 10% or 15%, then qualified dividends are subject to a 0% tax rate.
To qualify for the 0%, 15%, or 20% maximum rate, all of the following requirements must be met:
The dividends must have been paid by a U.S. corporation or a qualified foreign corporation. See chapter 1 of Publication 550 for the definition of a qualified foreign corporation. The dividends are not of the type excluded by law from the definition of a qualified dividend. See chapter 1 of Publication 550 for a list of these types of dividends. You must meet the holding period requirement (discussed next). You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it. See chapter 1 of Publication 550 for more information about qualified dividends.
Mutual funds that pass through dividend income to their shareholders must meet the holding period test for the dividend-paying stocks that they hold in order for the amounts they pay out to be reported as qualified dividends on Form 1099-DIV. In addition, investors must then meet the holding period test for the shares owned in the mutual fund in order for the qualified dividends reported to them to be taxed at the lower rates. If investors do not meet the holding period test, they cannot claim the lower tax rate on the qualified dividend income reported to them on Form 1099-DIV and must classify the qualified dividends as ordinary dividends.
Capital gain distributions (also called capital gain dividends) are paid to you or credited to your account by mutual funds. They will be shown in box 2a of the Form 1099-DIV (or similar statement) you receive from the mutual fund.
Report capital gain distributions as long-term capital gains, regardless of how long you owned your shares in the mutual fund.
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550 Investment Income and Expenses