Planning for your personal tax return becomes more complicated each year. Townhall reports that the federal tax code (CCH Standard Federal Tax Register) is over 73,000 pages long. If you have an unexpected taxable event, the process of planning for your tax liability is even more complicated. A mutual fund may generate more taxable income that you expect.
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Tax deferred vs. currently taxable
For starters, make sure that you understand whether your mutual fund is in a tax-deferred account, or an account that is taxed each year. If you invest through work, you may be using a tax-deferred vehicle, such as a 401(k).
Generally speaking, investments that are defined as retirement plans are tax-deferred. In addition to your 401(k), your IRA account may also grow tax-deferred. Ask your employer or your financial advisor to clarify the tax impact of your mutual fund investment.
Three areas of tax
If your mutual fund is taxable each year, here are three areas that will cause your mutual fund to incur taxes. So, consider these warning signs for each type of tax:
· Interest: Interest earned on corporate bonds, agency bonds and many government securities is taxable. If you own a bond fund, be aware that interest earned on bonds is taxable.
· Dividends: Dividends earned on common stock is also taxable. Many stock funds focus on buying high dividend stocks as a part of the fund’s investment objective. If the goal is to own stocks that pay a higher than average dividend, that will generate higher taxable income. Read the summary prospectus for your mutual fund to verify that fund’s investment objective.
· Realized Capital Gains: Buying and selling securities generates realized capital gains, which are taxable. These gains can be generated for both bonds and stock sales. If your fund sells securities at a loss, the losses are used to offset gains. A fund that ramps up its trading activity will generate more gains and losses. Check your fund’s portfolio turnover rate. The turnover rate indicates how much securities trading the fund is generating.
Fortunately, there are tools that can help you determine the impact of taxes on your mutual fund’s performance. Morningstar is a great site to review mutual fund performance. One statistic they use is Tax Cost Ratio. This ratio measures how much a fund’s annualized return is reduced by taxes. Take a look at the ratio for your fund.
Use these tools to see the warnings signs that you taxable mutual fund may create a tax liability for you. Include any tax liability in your planning for the year. Doing this work upfront will help you plan for next April 15th, and give you some peace of mind.
Have you dealt with a frustrating mutual fund taxation issue? I’d love to hear from you.
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