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Fund Taxation
Old 04-08-2011, 02:24 PM   #1
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Fund Taxation

Hi,

Can I get some links or references that will help me to figure out how taxation for mutual funds, specifically index funds, usually works?

I'm trying to run up Excel calculations for increasing net worth that take into account the fact that my taxes will go up as my dollars compound, but I am getting lost when I try to figure out what tax rates to apply to dividends/capital gains/regular income. Even if I flatten out the average gain to a simple X% value, there still has to be some way of accounting for capital gains vs. dividends when I figure taxation, right? Or... not right? I am kind of lost on this, and the more searching I do, the less information I seem to come up with. I keep finding websites that want to explain the concept of tax efficiency - and I get the idea that high turnover results in high capital gains and higher taxes - but that information does not give me any numbers to work with.

Anyone have some good references to pass my way? It would be much appreciated.
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Old 04-08-2011, 02:58 PM   #2
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Everything you want, all in one convenient location

Mutual Fund Tax Guide
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Old 04-08-2011, 03:06 PM   #3
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Actually for any mutual fund, if you don't reinvest the dividends, you get taxed on any distributions as they are made (in the index fund basicallly the dividend payments) These go at the dividend rate. If there are any capital gains distributions you pay capital gains on these. Finally when you sell you pay capital gains on the increase in value between the basis, and what you get. If you re-invest the distributions you need to add them to the basis (since you already paid tax on them).
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Old 04-08-2011, 03:07 PM   #4
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IRS Publication 17 has just about everything you need to know about taxes on capital gains and dividends.
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Old 04-08-2011, 06:12 PM   #5
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Straight from the IRS: Publication 564 (2009), Mutual Fund Distributions
and Publication 550 (2010), Investment Income and Expenses

PDF versions are also available.
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Old 04-08-2011, 07:18 PM   #6
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Originally Posted by meierlde View Post
Actually for any mutual fund, if you don't reinvest the dividends, you get taxed on any distributions as they are made (in the index fund basicallly the dividend payments) .
....."if you don't reinvest the dividends"........is there a reason this phrase is here? Would the rest of the statement be different if dividends were reinvested? The statement as written might lead someone to conclude that the dividends would not be taxed if they were reinvested.
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Old 04-08-2011, 09:25 PM   #7
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....."if you don't reinvest the dividends"........is there a reason this phrase is here? Would the rest of the statement be different if dividends were reinvested? The statement as written might lead someone to conclude that the dividends would not be taxed if they were reinvested.
If you reinvest the dividends after you pay the taxes in the year received you would add the dividends to the basis of the fund. I.E. if you paid $1000 for the fund, and got a $10 dividend that you re-invested, the next year your basis would be $1010. If you sold it then you would take the amount received and subtract the $1010 to determine the capital gains. (This would also apply to capital gain distributions) Of course going forward the mutual fund company would by law have to provide you the figure, but going back you get to do it.
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Old 04-09-2011, 12:53 PM   #8
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If you reinvest the dividends after you pay the taxes in the year received you would add the dividends to the basis of the fund. I.E. if you paid $1000 for the fund, and got a $10 dividend that you re-invested, the next year your basis would be $1010. If you sold it then you would take the amount received and subtract the $1010 to determine the capital gains. (This would also apply to capital gain distributions) Of course going forward the mutual fund company would by law have to provide you the figure, but going back you get to do it.
You seem to have made this waaaaaay more complicated than it needs to be.

Dividends are taxed as ordinary income -- period. It makes no difference what you do with the dividends.

If you choose to reinvest the dividends, that is just another "buy" transaction. As with the original "buy", the shares bought in this transaction have their own basis -- what you paid for the shares.

When you sell, you can use average share price or identify specific shares to determine the basis.

To be clear, we are talking about after-tax accounts, not tax deferred accounts.

Edit to add: Regarding this part: "...got a $10 dividend that you re-invested, the next year your basis would be $1010." the basis increases when the "buy" is made, not the next year.
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Old 04-09-2011, 01:17 PM   #9
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what rustward said +1

And you don't have to account for mutual fund (or any asset's) capital gains until the time period that you sell them. So don't add in a tax liability every year for that.

However Mutual funds do buy and sell within the fund without you making any trades at all. Those are sent to you as capital distribution gains. Some years you can have big losses (unrealized) and still get hit with the mutual funds trades.
If you don't believe this invest some money with Janus and test it out.
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Old 04-09-2011, 02:25 PM   #10
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Dividends are taxed as ordinary income -- period. It makes no difference what you do with the dividends.
To avoid confusing OP........2nd sentence is true. 1st sentence perhaps should be worded as.......dividends are taxed as dividends......sometimes as qualified dividends (at least for a few yrs) and sometimes as ordinary income.
It is likely that a "normal" equity index fund would have mostly qualified dividends which are taxed the same as long term capital gains (sometimes, depending on your other income, taxed at 0%). Hopefully, the IRS manual explains it more clearly than this.
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Old 04-09-2011, 02:43 PM   #11
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You are absolutely right. I was having trouble with the part about adding distributions to the basis.
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