How Capital Gains from Mutual Funds Are Taxed in the U.S.

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How Capital Gains from Mutual Funds Are Taxed in the U.S.

Filling out Form 1040 might be intimidating if you hold mutual funds that are not in a tax-free account. On some forms, there is a daunting variety of regulations and computations. However, there are a variety of strategies to make your mutual fund investments tax-efficient.

Key Takeaways

  • The capital gains tax rate applies to stock funds.
  • Bond funds are taxed differently, and some are even tax-free, such as municipal bond funds.
  • International funds are often taxed (once) at the tax rate of the issuing country. However, if the issuing nation does not have a tax compact with the United States, you may be required to pay taxes twice.
  • Investing in tax-advantaged accounts such as 401(k)s or IRAs guarantees that you maximize your tax-savings potential.

Stock Funds

A stock fund’s tax burden differs from that of a bond fund. Stock funds are taxed on capital gains if they trade the component equities. They also make distributions, which are taxed as well.

There are two rates for capital gains: short-term (less than one year) and long-term (for assets held longer than one year).Long-term capital gains are limited to 20% of the original investment. The majority of individuals pay the 15% or 0% rate. Short-term profits are subject to regular income taxation.

Stock funds may pay distributions in the form of dividends or profits from stock sales; in the latter instance, they may be taxed at the long-term capital gains rate. Dividend tax rates differ depending on whether they are “qualified” or “ordinary” dividends.

Dividends that are “qualified” are taxed at the same rate as long-term capital gains, but dividends that are “ordinary” are taxed at standard income tax rates of up to 37%. Fund distributions are taxed whether or whether the money is reinvested in new fund shares. There are also taxes to consider if the fund shares are sold at a profit (or deductions if there is a loss).

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Bond Funds

Bond funds are an exception. The interest is taxed like regular income. However, depending on the kind of bond fund you purchase, there are some additional complications. There are tax-free municipal bond funds, for example, but the tax reduction normally only applies if you reside in the same state as the bonds were issued.

Municipal bond funds are generally not taxable at the federal level, but federal debt (e.g., Treasury Bill funds) is free from state income tax but taxable at the federal level.

International Funds

This brings us to the third kind of fund: international. Because of the foreign tax credit, overseas funds are not always taxed.

To avoid charging individuals twice, the Internal Revenue Service (IRS) grants credits for previously paid foreign taxes. As a result, they may serve as a strong diversifier as well as a tax hedge. However, it’s critical to consider which nations the money cover. You may be taxed twice if you live in a country that has a tax treaty with the United States.

Tax Efficiency

Even if the tax laws for funds are intricate, tax efficiency may nevertheless be enhanced. First, reduce trading. A fund that trades often will pay more taxes, period. Bond funds may be placed in a 401(k) or individual retirement account (IRA), for example, whereas stock funds are kept in a taxable account. The reason for this is that bond fund payouts are taxed at the same rate as your income, so there will be a tax hit every year.

There’s also no assurance that stock funds will outperform bond funds (or vice versa) or that interest rates will stay low, so the easiest solution is to postpone paying taxes until you remove the money.

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Meanwhile, stock funds are taxed at the capital gains rate, which is often lower than the rate on regular income. That is, paying the lower rate every year is preferable than paying the higher rate on the revenue from selling off the fund shares later on.

An exchange traded fund is one sort of index fund (ETF).ETFs may be more tax-efficient than mutual funds because rebalancing ETFs do not have to pay the same taxes as mutual funds. In actuality, fund managers will nearly always sell the equities with the greatest cost basis first, which means they’ll get rid of the stuff that’s losing money or generating less money and pay less in capital gains.

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