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Don't Get Taxed for Bad Timing on Your Mutual Fund

Don't Get Taxed for Bad Timing on Your Mutual Fund No matter how much money they make, nobody likes to pay taxes. But the worst thing in the world is paying taxes when you never actually earned the income you're getting taxed on.

Unfortunately, that's exactly what happens every year around this time. With many mutual funds paying large taxable distributions at the end of the year, you have to be extremely careful if you decide to make big investments in December. Otherwise, you could end up with a big tax bill that you don't really deserve.

This Tax Is Out of Your Control

When you own stocks, the way you get taxed is pretty simple to understand. In most cases, if a stock pays a dividend, then you'll include that income on your tax return for the year and pay tax on it. But no matter how much the stock price goes up, you'll never pay taxes on the gains until you decide to sell the stock. That puts you in full control of when you'll pay capital gains taxes and is an incredibly valuable way to take advantage of tax deferral even without a tax-favored retirement account like an IRA or 401(k).

For reasons only the IRS fully understands, however, mutual fund shares follow different rules. With mutual funds, tax rules look inside the fund to determine whether you owe taxes on income. So if the fund receives dividend or interest income, then the fund is required to pay it out to you, and you'll pay tax on it. But even worse, if the fund buys or sells investments inside its portfolio, then you'll end up paying any capital gains that result -- even if you never sold your shares. In fact, even if you do what millions of investors do and reinvest your mutual fund distributions to buy more fund shares, you still have to pay tax on that money.

The Loophole Congress Left Open

The sad thing is that all this could have been a thing of the past by now.

Last year, Congress came close to enacting tax law changes that would have eliminated the unfair treatment of long-term mutual fund shareholders. But lawmakers got bogged down in what many considered more pressing tax issues, and so tax reform for mutual funds got pushed aside once more.

Without that relief, you're largely on your own to protect yourself from big fund distributions.

Three Ways to Avoid an Unfair Tax

It's important to remember that all of these issues only affect mutual funds in regular taxable accounts. If you own a mutual fund in an IRA or 401(k), you don't have to worry about any of this. However, if your funds are outside of these accounts, here are some ways you can potentially save yourself a tax mess:
  1. If you're considering making an investment in a mutual fund this month, see if it's planning to make a large year-end distribution. If it is, hold off on buying new fund shares until after the fund makes that distribution. Because the tax consequences depend entirely on who was a shareholder at the time the fund pays out its income, you'll avoid any taxes by waiting.
  2. Similarly, if you're thinking about selling shares that you've owned for a long time, think about selling them before a big distribution. By doing so, you may be able to avoid what would have been interest or short-term capital gains income -- taxable at a potentially much higher rate -- and instead get favorable long-term capital gains treatment.
  3. However, if you sell shares you've owned for less than a year, you may actually want to take the distribution. That's because by selling, all of your gain will count as short term and incur a high tax rate. But if you take the distribution, some of that gain may effectively get transformed into dividend or long-term capital gains, which enjoy a better rate.

For good or ill, you have to stay aware of esoteric tax laws like this if you want to avoid paying the IRS more than you need to. By making the right moves with your mutual fund investing, you can save yourself from unnecessary higher taxes.

Motley Fool contributor Dan Caplinger doesn't mind taxes but hates dumb taxes. You can follow him on Twitter here.

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December 26 2011 at 8:33 AM Report abuse rate up rate down Reply
Robert & Lisa

We got out of the stock market and are living better than ever and don't have the worries. It's rigged for and by the big boys. Obama and thugs rule.

December 09 2011 at 7:43 PM Report abuse +2 rate up rate down Reply
BOB SIMS ROCKS

Should have printed this article in Nov.

December 09 2011 at 1:54 PM Report abuse +1 rate up rate down Reply
scottee

Bad timing tax?
give us a fair or flat tax with no loopholes, no deductions, no filing and no involvement by congress! please!

December 09 2011 at 7:38 AM Report abuse +2 rate up rate down Reply
tkizzycat

Oh yes are law makers...stalled...they cant get their heads out of their A**s..........

December 08 2011 at 8:09 PM Report abuse rate up rate down Reply
1 reply to tkizzycat's comment
scottee

and we keep re-electing them....why????
they decide their own salary and benefits....why????
they earn six figures....why?????

December 09 2011 at 7:39 AM Report abuse +1 rate up rate down Reply
bech5514

The article fails to mention taxes are not 100% (obvious, right?) The article incorrectly assumes taxes are =/> 100%. Hence if you choose, the fund will pay you the dividends instead of reinvestment, and the money is there to pay A PART of as taxes (

December 08 2011 at 2:01 PM Report abuse rate up rate down Reply
carln246

to sfamilyent: how were you able to claim losses........I browsed the net a few months ago and came away with the impression that was NOT DOABLE!

December 08 2011 at 2:01 PM Report abuse rate up rate down Reply
carln246

Interesting that this is a one-way street, when you have losses in an MF, you can not claim them, yet you are entitled to pay taxes on your gains.............ain't it grand !!!

December 08 2011 at 1:57 PM Report abuse rate up rate down Reply
1 reply to carln246's comment
scottee

demand FairTax.org

December 09 2011 at 7:39 AM Report abuse rate up rate down Reply
1 reply to scottee's comment
Henry ptnm

I got this from Political Correction Website: This is according to Bruce Bartlett, Tax Analyst Report: Under the Fair Tax, every time you purchase a service, you would probably get 2 prices_ one you can pay with a check or credit card that includes the Fair Tax and one you can pay in cash and save 23%. Because there would no longer be any audits of income, since the IRS would have been abolished, tracing such tax evasions would be extremely difficult. This is how underground economies and illegal drug activities will run. No paper trace and no money trace. Fair Tax taxes food, clothing, rent, housing, utilities, everything medical, hospital stays, doctor visits, prescriptions, gas, auto repairs and so on. The so call prebates won't even cover that much. Fair Tax is also very unfair for retirees and seniors who live on fixed incomes. Some Fair Tax, isn't it?

December 13 2011 at 7:55 AM Report abuse rate up rate down
foxylynx

I got out of Mutual Funds the end of 2007, got tired of watching my money slip through a seive and I couldn't do a thing about it. Now I just own individual stocks and can sell them at any point and not have to wait till the end of the day, which is a big rip off. My stocks have done much better than the Mutual Funds and I have bought some really nice dividiend stocks and stocks in oil and gas.

December 07 2011 at 6:05 PM Report abuse +1 rate up rate down Reply
1 reply to foxylynx's comment
Ed Invests

I have tried to have a diversified portfolio and have gone merrily along with far too much in Mutual Funds,, and many re-invested. It's probably not a bad plan in good years, but I woke up about them this year. I will soon get out of all of them, but taking a loss on them right now is irritating. I commend you for your foresight and getting out when you did. I would be looking at a profit rather than a loss this year if I had invested in stocks last year instead of hanging on to the funds. Large dollar swing for me. I also agree that it is a pain to :":guess:" about the value when you sell.

December 08 2011 at 3:20 PM Report abuse rate up rate down Reply
lejn42

It would help a lot if articles like this could be printed out in the same form as they appear on the screen. Here, two pagesare magically and foolishly transformed into 13.

December 07 2011 at 10:33 AM Report abuse +1 rate up rate down Reply