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How Mutual Funds Are Taxed By Capital Gains in the United States

Triston Martin

Jan 05, 2024

Tax obligations for stock and bond funds are different from one another. If stock funds trade the component equities, they are subject to capital gains tax. Additionally, they make taxable payouts. Short-term (less than a year) and long-term rates are available for capital gains (for assets held longer than one year). A maximum of 20% is allowed for long-term capital gains. Most people pay a 15% or 0% rate. Gains made quickly are subject to regular income tax. When stock funds distribute money, it may be in the form of dividends or just profits from stock sales; in the former instance, the long-term capital gains rate may apply to the taxation of the distribution. Dividend tax rates vary according to whether they are "qualified" or "ordinary" dividends.

Mutual Fund Taxes

Mutual funds are a fantastic option for investors since they allow you to hold a diverse portfolio of assets for a low cost. But if you put your money into a mutual fund, you don't get to choose which stocks the fund buys or sells. The fund manager will decide. The fund's price, or its NAV (Net Asset Value), will go up and down depending on how well its holdings do.

Bond funds

Bond funds are a little bit unique. Ordinary income is what is used to tax the interest earned. But depending on the type of bond fund you choose, there are some additional complications. Some funds invest in tax-free municipal bonds but usually speaking. You can only benefit from this tax cut if you reside in the same state as the bonds were issued. Municipal bond funds are typically not subject to federal income tax, whereas national debt, such as Treasury Bills funds, is not subject to state income tax but is. Dividends that are "qualified" are taxed at the same rate as long-term capital gains, whereas dividends that are "ordinary" are subject to regular income tax rates, which can reach 37%. Fund distributions are taxed regardless of whether the money is reinvested into additional fund shares. Of course, taxes apply if the fund shares are sold at a profit.

Worldwide Funds

Thus, we arrive at the third type of funds—international. Because of the foreign tax credit, funds from abroad are occasionally not taxed. The Internal Revenue Service (IRS) offers credits for previously paid foreign taxes to prevent double taxation. As a result, they may serve as a helpful tax hedge and diversifier. However, paying close attention to the nations the funds cover is crucial. You can be subject to double taxation in countries with tax treaties with the United States.

Tax Efficiency

Tax efficiency can still be maximized even though the financial regulations for taxes are complex. Reduce trading first. Taxes will always be higher for a fund that trades a lot. For instance, bonds can be placed in retirement accounts like 401(k)s and IRAs, whereas stock funds are kept in taxable accounts. Because distributions from bond funds are taxed at your income tax rate, there will always be a tax burden. Deferring taxes until you accept the money is the simplest choice since there is no guarantee that stock funds will outperform bond funds (or opposite) or that interest rates will remain low.

On the other hand, stock funds are subject to capital gains tax, which is frequently less expensive than the rate on a regular income. Accordingly, paying the lower rate annually is preferable to paying the higher rate on future fund share sales proceeds. An exchange-traded fund is a particular kind of index fund (ETF). Because rebalancing ETFs do not incur the same taxes as mutual funds, they can be more tax-efficient than mutual funds. Fund managers always unload equities with the most significant cost basis first, allowing them to realize a smaller capital gain and sell the stocks that are losing money or producing less money.

Keeping Track of Your Profits and Losses

If you sell your shares in a mutual fund, you don't have to pay taxes on any of the money you get back because you already paid taxes when you earned it. Because of this, it's essential to know how to figure out how much of your distribution comes from gains and how much comes from investments. To determine how much of your investment income is a gain or loss, you must first know how much you paid for the shares you sold. This part is called the "base." Mutual fund shares are often bought at different times, in different amounts, and at different prices, so it can be hard to figure out how much you paid for a specific share.

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