Message Font: Serif | Sans-Serif
No. of Recommendations: 4
<my DH says that the obligation to pay capital gains tax is satisfied by paying the 1099-DIV capital gains, and that I don't have to pay a capital gains tax on the sale. DH tends to be very confident, whether he is an expert on the subject or not ;-), so he has gotten me confused.>

Hopefully, your DH has plenty of other qualities that make it worthwhile keeping him around.<g> Don't allow him to further confuse you when it comes to taxes.

An easy way to look at this is that any distribution from the fund is a taxable event for all fund holders in that calendar year. You have no control over that event as long as you maintain your position. A sale by you is an individual taxable event to you that you do have complete control over. The two events are separate transactions that must both be accounted for on your tax return. They are related in that any distributions that are reinvested will result in an equal change to your cost basis. So if the fund declares a $2 distribution and you have 500 shares, it will result in a 1k taxable event for you. If you take the 1k in cash, you do not adjust your cost basis. If you do reinvest it, you need to add 1k to your cost basis. This will prevent you from paying taxes a second time on that 1k later on when you sell.

A further example of this would be if you made a 10k purchase of a fund. Say over a few years you have received 5k in distributions that were reinvested. Your adjusted cost basis would now be 15k. If you sell at that time your net gain or loss would be determined by taking your net proceeds and subtracting your 15k cost basis. So if you sold for 16k you would have a 1k gain. If you sold for 14k you would have a 1k loss. The LT or ST amount would be determined by the holding period for each block of shares (original buy plus each reinvestment). If you fail to track all of this and only used your original basis of 10k, your 14k sale would result in a 4k taxable gain rather than a 1k taxable loss. In such a case, you would be paying taxes a second time on the 4k. This only points out that good records are not a luxury, but a real necessity.

The breakdown of any annual distributions are determined by the fund. So it is entirely possible that you could own a mutual fund for only a few days and still end up with LTCGs. They are merely passing through to you the net outcome of their calendar year transactions. That is why you hear so much talk this time of year about "not buying the dividend". If you buy 1k shares of a fund right before they make a $5 distribution you have just bought yourself a 5k addition to your current year income. Your total investment will still net out the same since the 5k distribution will be offset by a 5k drop in the value of your holding. Waiting until after the distribution allows you to make the purchase without any current year tax obligations.

BTW, it is also possible for your fund to be down 50% and still pass through lots of CGs to shareholders. Every time we go through a down year there are loads of people who learn this the hard way. The price of the fund and the amount of distributions are often not correlated at all. That is why it is important to understand a funds stated purpose and their turnover ratios. If a fund has a ratio of 200% I would not expect to see lots of LT gains as its average holding period would only be a few months. OTOH, a ratio of 10% would indicate that the fund does not do very much selling in a typical year.

It is beyond the original question raised, but high turnover ratios are almost always accompanied by higher expense ratios. High costs such as loads, 12B-1 fees, high management fees and large annual expenses will take a big bite out of your total returns in the long haul. That does not make it wrong to invest in such a fund, but it could very well be. Your goals and a funds goals should be on the same page. The key is to avoid having to admit well after the fact that you did not really understand a particular investment.


Print the post  


In accordance with IRS Circular 230, you cannot use the contents of any post on The Motley Fool's message boards to avoid tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions.
Live Video Event Monday!
The GP team is hosting a live video event on Monday at 4 p.m. ET. Don't worry if you can't make it — we'll have a replay and a transcript. Click for more!
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.
Contact Us
Contact Customer Service and other Fool departments here.
Work for Fools?
Winner of the Washingtonian great places to work, and Glassdoor #1 Company to Work For 2015! Have access to all of TMF's online and email products for FREE, and be paid for your contributions to TMF! Click the link and start your Fool career.