Tax Benefits of Mutual Funds in USA

by Manshu on November 27, 2006

in Mutual Funds

In America, there are two ways to invest in Mutual Funds. There are people who give taxes annually depending on their capital gains or the dividend received from the fund. The capital gain taxes are levied on the money received when appreciated assets are sold out. These taxes are ample as compared to gains and largely reduce the performance of Mutual Funds. Secondly, there are people who buy under mutual funds scheme of tax-advantaged retirement plans like IRAs and 401(k)s. These people enjoy tax-benefits on reinvested dividends, capital gains and asset accumulations.

Capital gains occur when the profit in capital asset is cashed. These gains as well as those, which are not realized i.e. the stock prices that have increased but not sold ,are taxed. Even if an investor buys and sells shares a large amount of tax is levied due to distribution of profit from their mutual funds. In case of Mutual Funds an extra point that generate a legal tax responsibility is selling of stocks by Mutual Funds producing tax on unrealized gains for each person investing in Mutual Fund.

Mutual Funds despite their numerous advantages have several tax drawbacks that make incautious investors surprised. Suppose you sell mutual funds without maintaining records of reinvested dividends and capital gain or you wrote off checks on funds – Beware! You might have generated a taxable sale. The tax implication of the funds go much beyond your thought become visible on the Form 1099 introduce by the funds. One pays tax on the dividends and capital gains incurred. So if these are inevitably reinvested and if any part of the investment is sold then appropriate care must be taken on your part to add a proportionate part of the earlier tax to avoid double taxation. Even changing from one fund to a different one i.e. switching under the same banner of funds is not tax-free. Rather it is seen as a sale and reinvestment. However, such swapping within a retirement plan account like IRA, 401(k), Keogh, is not taxable.

Now consider the check writing privilege on a mutual fund account. If you write any check, it’ll be treated as selling of shares and should be reported on Schedule D, Capital Gains and Losses. Also if there is no profit or loss in the transaction, it must be reported. Any lapse would throw off the resolution of aggregate sales price per the return and sales earnings informed on Forms 1099-B, Proceeds From Broker and Barter Exchange Transactions, furnished to the IRS.

However as the taxes on mutual fund grew , the efficiency of this mutually beneficial scheme of low and middle class homes was question marked. The tax laws in America then underwent few changes where investing in mutual funds except that your retirement plan can give tax– saving opportunity. By the new laws implemented in 2002, your savings are not tax–deferred as in Traditional IRA or 401(k) plan but the taxes are reduced considerably.The top tax rate on qualified dividends has been reduced from 35% to 15%.The top tax rate on long–term capital gains has been reduced from 20% to 15%. Certain sectoral-schemes of Mutual Funds in America are exempted from taxes. These are calledTax–exempt bond funds.They generally invest in bonds issued by state and local governments to invest in projects such as hospitals, schools, airports, railways and highway. The dividends paid by these funds are relieved from regular federal income taxes. State–specific tax–free funds offer both federal and state tax advantages. So if you are paying a high tax you can benefit more by putting your money in tax–exempt bond funds.

The money invested in average stock mutual fund has been on an increase but the taxable distributions graph is on rise paving way to higher taxes. The markets are more volatile in America with large caps overtaking small caps. Other markets as real estate and energy stocks have been abrupt. So the fund manager style has changed a lot and they are trading more frequently, thus resulting in higher taxable gains. So if you want to invest in a mutual fund freshly, you must check up its distribution by checking up the portfolio. This is because if you end up paying taxes on capital gains you cannot achieve anything. Go for index funds or tax-managed funds with lesser taxable distributions, if you are looking to save taxes.

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