Mutual fund tax trap

This is not an article to tell you to sell all your mutual funds to avoid this tax trap. This is just a cautionary warning about how mutual fund dividends are taxed so you can have a plan before it's too late. Back when I prepared tax returns I always had clients that questioned why they had to pay taxes on the mutual fund dividends they reinvested when they had only owned the fund for just a few days and never received a check in the mail.

Mutual funds, investment companies and some holding companies all fall under a special IRS tax provision. If they do things properly, they are not taxed like a corporation but pass through their tax liabilities like a partnership. If at least once a year they pay out 90% all the net interest, dividend and trading profits they made during the past year they will not have to pay income taxes on those profits but instead pass through that liability to the owners of their shares.

It doesn't matter if you only owned the shares for just a few days, if you are the owner on the day they payout that dividend they pass through to you the tax liability. You will receive a statement telling you how much of the dividend is for interest, net short term and long term capital gains. If the fund you own hold bonds or real estate you may also be informed how much of the dividend is for tax exempt interest, taxable interest or even return of principal.

I know you usually buy a mutual fund to make your life simpler but at tax time it can make your life complicated. Do some planning now. Find out when the funds you own pays out that dividend and see how you will be taxed. After you receive the dividend there is not much you can do to avoid the tax liability.

I know some people who have owned a fund for the last 20 years and never sold it because it was a long term investment. Someone else prepares their tax returns and they never noticed that they paid taxes on these dividends year after year. They were under the false impression that they never paid taxes on their mutual fund gains until they sold them.

Before you start screaming that the tax code is unfair, I'll drop some more bombs on you. Most mutual funds turn their portfolios over several times a year. You may think you have a long term investment that will get long term capital gains treatments but look closely and you'll find out that most of the dividend was short term capital gains, taxed as ordinary income at your incremental tax rate.

Now the big bomb. They only get to pass through the net gains. If they had a net loss for the year, that net loss is carried forward not passed through to you.

In investing it's not how much you make that counts, it's how much to keep. How much do you get to keep after fees, taxes and inflation?

Jim Van Meerten is an investor who writes on financial matters here and on Financial Tides. Please leave a comment below or email FinancialTides@gmail.com