Tax planning and compliance for investors
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By Kaye A. Thomas
Updated February 2, 2008
An overview for people new to the subject.
Mutual funds offer a way to have your money managed as part of a large pool of money contributed by many investors. You gain two big advantages:
A mutual fund account can be similar to a bank account. You get started by filling out forms and writing a check for the initial deposit. After that you can make additional deposits and, when you need the money or want to make a different investment, take a withdrawal.
There are important differences though. A bank account doesn't lose value unless you withdraw money. In a mutual fund your account balance can decline if the investments chosen by the managers lose value. That risk is the price you pay for the higher rate of growth that's possible from a mutual fund.
Here's another important difference: as a mutual fund investor you aren't simply depositing and withdrawing cash, you're actually buying and selling shares of the mutual fund. This won't matter much if you hold your mutual fund investments in an IRA or other retirement account. In a regular taxable investment account it matters a great deal. Every time you take money from a mutual fund account you're selling shares, and you have to report gain or loss from that sale on your tax return.
All in the family. A mutual fund company may offer a variety of different funds and make it easy to move your money from one fund in this "family" to another. Even though you don't receive any money in this transaction you're considered to be selling shares in one fund and buying shares in another, and you'll have to report the sale on your tax return.
The sale can produce gain or loss depending on the basis of those shares, which is generally based on their original cost. Keeping track of basis can be tricky, especially if you maintain your investment for a number of years. Every deposit is a purchase of shares, adding to your basis. If you choose to have the fund reinvest your dividends, you're making an additional purchase every time the fund pays a dividend. Fortunately there are special averaging rules that make it easier to report gain or loss when you sell mutual fund shares. Better still, many mutual fund companies provide calculations you can use to report your gain or loss.
details: Selling Mutual Fund Shares
Mutual funds differ from bank accounts in another way. A bank account produces only one kind of income: interest income. Mutual funds can make many different kinds of investments, so they can produce different kinds of income:
Overall these rules are quite favorable because they allow you to claim many of the same tax benefits that would be available if you personally made the same investments the managers chose for the mutual fund. But the tax reporting for mutual fund dividends is more complicated than reporting for interest on a bank account or dividends you receive when holding shares of stock.
details: Mutual Fund Dividends
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