Mutual Funds and Taxes

[MichealKnight]

I'll use what I think is a mainstream fund for this question.

VWINX - Vanguard Wellsley

When owning a stock: Simple. You buy the shares, you get dividends and pay taxes on the dividends each year. You pay the capital gain - when you sell the stock.

On a Mutual Fund..... VWINX for instance shows a 1.84%yield. Of course, you'd pay taxes on that 1.84% each year.

Question.... do you incur tax liability, every time VWINX sellls shares for a profit? OR do you only incur capital gains taxes when you actually sell the mutual fund at a higher price than you bought it? Thanks

 

[jazz4cash]

You will incur some capital gains liability for activity within the fund. These will be reported to shareholders at year end. You can look for fund distributions on the summary report to see what the fund has done historically. This is why many investors consider high turnover to be a negative characteristic. It also contributes to the tax efficiency of Index funds.

Here’s the link to Wellesley’s distributions:
(Go to tab marked Distributions)

https://investor.vanguard.com/mutual-funds/profile/overview/VWINX

 

[Montecfo]

You pay tax on dividend distributions, and then capital gain or loss when you sell shares.

The fund may also distribute capital gain distributions which are also taxable as received.

If you receive distributions that are return of capital, they are not taxable but reduce your basis in the shares. This will increase your gain or reduce your loss when you sell.

 

[athena53]

Mutual finds are required to issue capital gain distributions every year if they have any. I've even seen a few that issued capital gain distributions mid-year. They're declared separately fore long-term and short-term gains. Most funds provide an estimate close to year-end so you can plan your taxes.

You pay taxes on those distributions in the year they're distributed but that reduces your "basis". So, if you buy $10,000 of a fund and they issue a capital gain distribution of $1,000 at year-end, your basis for calculating the profit or loss is $11,000.

 

[VanWinkle]

You pay tax on dividend distributions, and then capital gain or loss when you sell shares.

The fund may also distribute capital gain distributions which are also taxable as received.

If you receive distributions that are return of capital, they are not taxable but reduce your basis in the shares. This will increase your gain or reduce your loss when you sell.

I was not aware of this treatment of capital gains being taken as a reduction of cost basis. Can you clarify exactly how this works?

Thanks

VW

 

[Montecfo]

You pay taxes on those distributions in the year they're distributed but that reduces your "basis". So, if you buy $10,000 of a fund and they issue a capital gain distribution of $1,000 at year-end, your basis for calculating the profit or loss is $11,000.

Capital gain distributions do not change your basis. However if you reinvest distributions, that is a new investments for which you will have a basis equal to that new investment.

I think that may be what you meant?

 

[Montecfo]

I was not aware of this treatment of capital gains being taken as a reduction of cost basis. Can you clarify exactly how this works?

Thanks

VW

Not capital gains. Return of capital.

These are more common with REITS and closed end mutual funds, but they can occur with open end mutual funds as well.

 

[VanWinkle]

Not capital gains. Return of capital.

These are more common with REITS and closed end mutual funds, but they can occur with open end mutual funds as well.

The confusion may have occurred due to OP post which was for
Wellesley which is not a REIT or closed end fund.

A capital gain within a open end mutual fund is a taxable event for the
year that the gain was realized. I am not aware of a way to get around
that fact.

 

[Montecfo]

The confusion may have occurred due to OP post which was for
Wellesley which is not a REIT or closed end fund.

A capital gain within a open end mutual fund is a taxable event for the
year that the gain was realized. I am not aware of a way to get around
that fact.

Agree. And return of capital distributions, which are different from capital gain distributions, reduce basis for gain or loss.

True for Wellesley and for any other mutual fund.

 

[Alan]

For a mixed fund like Wellesley you will get dividends from the bonds within the fund and also the stocks. Dividends from stocks are taxed more favorably than from bonds. (Dividends from bonds are treated the same as interest from savings accounts)

The dividend statement will show how much of the dividend is “qualified as being from stocks” and gets the favorable tax treatment.

 

[VanWinkle]

Agree. And return of capital distributions, which are different from capital gain distributions, reduce basis for gain or loss.

True for Wellesley and for any other mutual fund.

That makes sense as this return of capital is actually giving you some of your original after tax investment back to you. I never knew a non reit/non mlp fund to do that, but I live in a small uncomplicated investment world.

 

[gcgang]

Question.... do you incur tax liability, every time VWINX sellls shares for a profit? OR do you only incur capital gains taxes when you actually sell the mutual fund at a higher price than you bought it? Thanks

The fund incurs realized capital gains every time they sell shares for a profit. You may not incur a tax liability as rhe fund could also sell shares to incur an offsetting loss. But usually, yes, you pay taxes even if you didn’t make money.

When you buy a mutual fund, you are buying into their cost basis, meaning you may incur tax liabilities even if YOU don’t make money.

For example, a fund may have a NAV of $10 when you buy it, but their underlying basis in those shares may only be $5. If they sold everything the day after you bought, you’d get a $5 per share taxable Capital gain distribution on which you’d owe taxes even though you haven’t made any money.

Of course, you could offset the gain by selling your shares at a loss, as the NAV of the fund declines by the amount of the distribution.

Especially now, with the market at all time highs, this embedded tax liability is a reason to not purchase mutual funds in taxable accounts.

 

[athena53]

Capital gain distributions do not change your basis. However if you reinvest distributions, that is a new investments for which you will have a basis equal to that new investment.

I think that may be what you meant?

Thanks. I do reinvest mine so that may be why I was thinking of them as increasing the basis. When I do sell I use whatever basis the brokerage reports, so my taxes are OK.

 

[TheWizard]

Especially now, with the market at all time highs, this embedded tax liability is a reason to not purchase mutual funds in taxable accounts.

I don't agree.
There are some reasons for not investing ALL of your taxable account money in stock funds, but putting more new money into broad INDEX stock funds is always a good idea.
Most of them seldom pay any Capital Gains Distributions.
And if your total market index fund declines in value by 10%, you can TLH by selling recently purchased lots and buying an S&P 500 index fund with the proceeds...

 

[athena53]

I don't agree.
There are some reasons for not investing ALL of your taxable account money in stock funds, but putting more new money into broad INDEX stock funds is always a good idea.
Most of them seldom pay any Capital Gains Distributions.
And if your total market index fund declines in value by 10%, you can TLH by selling recently purchased lots and buying an S&P 500 index fund with the proceeds...

I agree- I'm moving towards index funds for this reason, especially in the after-tax accounts. A lot of taxes and other items such as stimulus checks are a function of your AGI. For people wanting to "manage" AGI (I haven't- I make too much just with SS, a couple of pensions, dividends, interest and voluntary sales to qualify for any breaks or avoid IRMAA, which I guess is a good thing), unexpectedly high CG distributions can really throw you off track.

 

[pb4uski]

I'll use what I think is a mainstream fund for this question.

VWINX - Vanguard Wellsley

When owning a stock: Simple. You buy the shares, you get dividends and pay taxes on the dividends each year. You pay the capital gain - when you sell the stock.

On a Mutual Fund..... VWINX for instance shows a 1.84%yield. Of course, you'd pay taxes on that 1.84% each year.

Question.... do you incur tax liability, every time VWINX sellls shares for a profit? OR do you only incur capital gains taxes when you actually sell the mutual fund at a higher price than you bought it? Thanks

Mutual funds are similar to what you outlined for stocks... you buy shares, you get dividends and pay taxes on dividends each year and pay capital gains tax when you sell.

The only difference is that you get two kinds of dividends... income dividends which usually regular and are similar to stock dividends... and capital gains distributions which are distributions of realized capital gains of the fund.

 

[audreyh1]

Mutual finds are required to issue capital gain distributions every year if they have any. I've even seen a few that issued capital gain distributions mid-year. They're declared separately fore long-term and short-term gains. Most funds provide an estimate close to year-end so you can plan your taxes.

You pay taxes on those distributions in the year they're distributed but that reduces your "basis". So, if you buy $10,000 of a fund and they issue a capital gain distribution of $1,000 at year-end, your basis for calculating the profit or loss is $11,000.

Only true if you automatically reinvest that distribution.

Otherwise your unrealized gain in the fund has dropped by $1,000 as the value drops when that $1,000 is paid out, but your cost basis remains the same.

 

[SecondCor521]

For a mixed fund like Wellesley you will get dividends from the bonds within the fund and also the stocks. Dividends from stocks are taxed more favorably than from bonds. (Dividends from bonds are treated the same as interest from savings accounts)

The dividend statement will show how much of the dividend is “qualified as being from stocks” and gets the favorable tax treatment.

Things may be different across the pond, but AFAIK all US bonds pay interest and none pay dividends, which is why the tax treatment of bond income is the same as interest. It's because it is interest.

Also, as long as I am on a pedantic roll, the term "qualified" when applied to dividends has to do with the holding period of the stock (it's something like 60 days prior to and 60 days after the dividend is paid or somesuch), not the fact that it is a stock dividend in and of itself.

 

[Rustward]

...
Also, as long as I am on a pedantic roll, the term "qualified" when applied to dividends has to do with the holding period of the stock (it's something like 60 days prior to and 60 days after the dividend is paid or somesuch), not the fact that it is a stock dividend in and of itself.

I was waiting to see if anyone else caught that and I am glad to say that at least one person did and cared enough to post about it.

There are specific requirements for a dividend to be considered as a qualified dividend.

From https://www.investopedia.com/terms/q/qualifieddividend.asp

1. The dividend must have been paid by a U.S. company or a qualifying foreign company.
2. The dividends are not listed with the IRS as those that do not qualify.
3. The required dividend holding period has been met.

Feel free to check other sources.

 

[VanWinkle]

The fund incurs realized capital gains every time they sell shares for a profit. You may not incur a tax liability as rhe fund could also sell shares to incur an offsetting loss. But usually, yes, you pay taxes even if you didn’t make money.

When you buy a mutual fund, you are buying into their cost basis, meaning you may incur tax liabilities even if YOU don’t make money.

For example, a fund may have a NAV of $10 when you buy it, but their underlying basis in those shares may only be $5. If they sold everything the day after you bought, you’d get a $5 per share taxable Capital gain distribution on which you’d owe taxes even though you haven’t made any money.

Of course, you could offset the gain by selling your shares at a loss, as the NAV of the fund declines by the amount of the distribution.


Especially now, with the market at all time highs, this embedded tax liability is a reason to not purchase mutual funds in taxable accounts.

You mean do not buy active funds- Most index funds will not have this problem.

 

[SecondCor521]

I was waiting to see if anyone else caught that and I am glad to say that at least one person did and cared enough to post about it.

There are specific requirements for a dividend to be considered as a qualified dividend.

From https://www.investopedia.com/terms/q/qualifieddividend.asp

1. The dividend must have been paid by a U.S. company or a qualifying foreign company.
2. The dividends are not listed with the IRS as those that do not qualify.
3. The required dividend holding period has been met.

Feel free to check other sources.

Yes, you're correct (and have out-pendanticized me - congrats! ). I usually forget about items 1 and 2 on your list because 99% of the time people just buy run-of-the-mill stocks and mutual funds that meet those criteria, so it generally boils down to the holding period.