A reader recently asked: "If mutual funds pay taxes each year on capital gains of stocks they sold, why does the investor also have to pay taxes on all the capital gains when he sells the mutual fund shares? Haven't most of the capital gains taxes already been paid by the mutual fund? It seems as if Uncle Sam is double dipping here."
Here's our response: A mutual fund doesn't pay taxes on capital gains of stocks sold during the year. You do. Funds report distributions of income from dividends, interest, and capital gains (net of losses) to the fund's shareholders (and to the IRS) on Form 1099.
Most shareholders have those distributions reinvested in additional mutual fund shares. (Note: Even if you do this, you must still pay the taxes due on the distribution.) When you liquidate your holdings in a mutual fund, you'll be taxed on any gain over the purchase price paid for each fund share held.
This isn't double taxation. You're taxed on gains from securities the fund bought and sold, and later, when you sell your shares of a fund, you pay taxes on the difference between your purchase price and the current price of fund shares. It's smart to keep records of all purchases, including those bought with reinvested dividends and capital gains.
Before you make a big investment in a mutual fund, find out when it will make its capital gains and dividend distributions. You'll receive those distributions -- and tax liabilities -- regardless of how long you've owned the fund. You don't want to invest in a fund right before the distribution, because you'll have to pay taxes on growth -- perhaps years' worth -- from which you didn't benefit. This is especially important right now, since most funds make their distributions at the end of the year.
Finally, you don't have to worry about any of these tax problems if you hold your funds in a retirement account such as an IRA.
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