What to know about paying taxes on mutual fund gains — and the SEC rule that can help investors choose between competing funds

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The good thing about equity mutual funds is they are managed by professionals. These folks should be (better be) well-qualified to judge which stocks are attractive bets.

The bad thing about funds, besides the fees, is that you don’t have much control over taxes. That’s because the fund — not you — decides which of its investments will be sold and when. If sales during the year result in an overall gain (very likely this year), you’ll receive a taxable dividend distribution, whether you want it or not —- assuming you hold the shares in a taxable brokerage firm account.

In fact, you can wind up owing taxes even though your fund shares have declined in value. Sorry about that. That happens when the fund sells shares that appreciated during the fund’s holding period, but the fund’s value went down after you bought in. In the not-too-distant past, this little scenario occurred with a vengeance and created some bad results for investors. And it could happen again. Hopefully not real soon, but you never know.

Taxable distributions

Why do funds insist on making taxable distributions? Because our beloved Internal Revenue Code requires them to pass out as dividend distributions almost all of their income and gains earned during the year. Otherwise they get hit with the corporate income tax, which wouldn’t help anyone except the U.S. Treasury.

Of course, the unwanted taxable distribution problem is of less concern with index funds and tax-managed (also called tax-efficient) funds. For the most part, index funds buy and hold, which tends to minimize taxable distributions. Tax-managed funds also lean towards a buy and hold philosophy, and when they do sell securities for gains, they try to offset the gains by selling some losers in the same year. This approach also minimizes taxable distributions.

Helpfully, the SEC requires mutual funds (other than money market funds and funds intended only for tax-advantaged retirement accounts) to disclose both pretax and after-tax rate of return information. Use those figures when choosing between competing funds.

In contrast, funds that actively churn their stock portfolios will usually generate hefty annual distributions in a rising market, like we’ve been having. The size of these payouts can be annoying enough, but it’s even worse when a large percentage comes from short-term gains. Distributions that arise from short-term gains are taxed at your regular federal rate, which can be as high as 37%, assuming no retroactive tax rate hike for this year. In addition, you may owe the 3.8% net investment income tax (NIIT), and you may also owe state income tax depending on where you live.

On the other hand, funds that generally buy and hold stocks for over one year will pass out distributions that are mainly taxed at no more than 20%, assuming no tax rate hike, although the 3.8% NIIT and state income tax can increase the tax bite considerably.

Biden’s proposed tax plan would raise the top federal income tax rate on net short-term capital gains

Starting in 2022, the proposed Biden tax plan would raise the top federal income tax rate on net short-term capital gains recognized by individuals, including those from mutual fund distributions, back to 39.6%, the top rate that was in effect before the Tax Cuts and Jobs Act lowered it to the current 37%. This proposed rate increase would affect singles with taxable income above $452,700, married joint-filing couples with taxable income above $509,300, and heads of households with taxable income above $481,000. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) versus the current maximum effective rate of 40.8% (37% + 3.8%).

The proposed Biden tax plan would also retroactively increase the maximum federal rate on net long-term capital gains to 39.6% for gains recognized after April of this year, though the exact timing is still unclear. After tacking on the 3.8% NIIT, the maximum effective rate would be 43.4% (39.6% + 3.8%) compared to the current maximum effective rate of “only” 23.8% (20% + 3.8%).

The proposed rate increase would only apply to taxpayers with adjusted gross income (AGI) above $1 million, or above $500,000 if you use married filing separate status. You would be subject to the higher maximum rate only to the extent your AGI exceeds the applicable threshold. For example, a married joint-filing couple with AGI of $1.2 million, including a $300,000 net long-term capital gain, would pay the 39.6%/43.4% maximum rate only on the last $200,000 of net long-term capital gain. Will this proposed retroactive near-doubling of the maximum effective rate on long-term gains get through a closely divided Congress? We shall see.

After-tax returns are what matter when choosing between competing funds

Assuming you are not among those who would like to pay higher taxes and you are investing via a taxable brokerage firm account, you should really be looking at what kind of after-tax returns various funds have been earning. Use those figures in choosing between competing funds. But if you are using a tax-advantaged account (traditional or Roth IRA, 401(k), Keogh, SEP, variable annuity, and so forth) to hold mutual fund investments, you can focus strictly on each fund’s pretax returns and ignore all this stuff about taxes.

Helpfully enough, the SEC requires mutual funds (other than money market funds and funds intended only for tax-advantaged retirement accounts) to disclose both pretax and after-tax rate of return information. In figuring after-tax returns, short-term gains distributed by the fund are assumed to be taxed at the highest federal ordinary income rate (currently 37%). Long-term capital gain distributions and long-term gains from selling fund shares are assumed to be taxed at 20%, for now. The same methodology must be used to compute any after-tax return information presented in advertisements and sales literature. This SEC rule makes it easier for investors to make informed comparisons of fund performance data, but you’ll have to do some reading to benefit.

Stay tuned for the rest of the story on mutual funds

With those basics behind us, please stay tuned for the second part of this two-part series coming next week. I’ll cover some important specifics about how mutual fund investments are treated under the federal income tax rules.

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