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Avoid Paying Double Taxes on Mutual Funds

November 11th, 2007 at 06:58 pm

As the end of the year draws near, mutual fund companies are required to distribute all of their capital gains and dividend income accumulated over the past year. If you have mutual funds, you likely reinvest these distributions into more shares of the mutual fund.

If you plan on selling a mutual fund soon, you might want to sell the fund before the year end distribution, to avoid paying taxes on this year's distributions. If you are planning on buying a mutual fund, you may want to wait until after the yearly distribution is made, to avoid paying taxes on gains in which you did not participate.

A costly mistake, that many people make, is not keeping track of their yearly distributions from mutual funds. Each year, you will pay taxes on the capital gains and dividend distributions from a mutual fund. If you reinvest your capital gains and dividends, when you decide to sell the mutual fund, these distributions should be included in your cost (basis) of the fund. If you forget to do this, you will end up paying taxes twice on these distributions.

As an example, suppose that you bought a mutual fund five years ago for $10,000. Each year you reinvest your $1,000 capital gains and dividend distribution. At the end of five years, your mutual fund holdings are valued at $17,000. What is your capital gain if you sell?

If you forget that you have already paid taxes on $5,000 of capital gains and dividend distributions, you might report a capital gain of $7,000. However, since you have already paid taxes on $5,000 of capital gains and dividends, your cost/basis is $15,000 and your capital gain is only $2,000.

If you buy and hold mutual funds, be sure to keep track of the reinvested gains that you receive and pay taxes on each year. This will keep you from paying Uncle Sam more than you should when you sell the fund.

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