Surprise! The mutual fund tax trap

tax surprises bring rejected tax returns via e-filingToo often, taxpayers receive tax surprises at year-end due to actions taken by mutual funds they own. What can add insult to injury is the unsuspecting taxpayer who recently purchased shares in a mutual fund only to be taxed on their recent investment. First, how does this happen? And, secondly, what can you do about it?

Tax surprises

Towards the end of each year, many mutual funds pay a dividend to the holders on record as of a set date. The fund might also distribute funds deemed capital gains based on buying and selling activity in the fund throughout the year. This can create many problems:

  • Taxable paybacks. If you purchase shares in a mutual fund just before distributing dividends, part of your purchase includes the dividends effectively paid back to you. The asset value of your recently purchased shares in the mutual fund goes down after the distribution. You will also owe tax on a distribution that is your own money!
  • Kiddie tax surprise. Many taxpayers purchase mutual funds in their children’s names to take advantage of their lower tax rates. The tax is low or nonexistent because they keep their child’s unearned income below $2,100. A surprise dividend or capital gain could expose much of this unearned income to higher tax rates.
  • The $3,000 loss strategy. Each year, you may take up to $3,000 in investment losses. Your losses can offset high rates of income tax with correct tax planning. But first, these losses need to offset capital gains. If you receive a surprise capital gain, then you could be reducing the effectiveness of this tax strategy.

What to do

Here are some ideas to help reduce this mutual fund tax surprise:

  • Limit year-end activity. Plan your mutual fund moves with this year-end surprise in mind. Consider reviewing and rebalancing your funds at the beginning of the year to avoid fund purchases just before dividend distributions.
  • Research your mutual funds. Research your mutual funds to anticipate what will happen with them and avoid a year-end surprise. Check out the historical trends of your funds in order to determine which are most likely to issue a surprise Form 1099 DIV or Form 1099 B (capital gain or loss).
  • Use the knowledge to your benefit. If you like a fund that has the practice of creating taxable events each year, then consider investing in these funds within a retirement account. That way, the tax implications can be part of your retirement planning.

No one likes a surprise at tax time. The best course of action regarding your mutual funds is to consult an expert who can help you navigate the best options. Please contact our RRBB advisors if you have any questions.


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