Mutual fund gains and losses have tax consequences

MUTUAL FUNDS

March 27, 1994|By WERNER RENBERG | WERNER RENBERG,1994 Werner Renberg

With the filing deadline for income tax returns approaching, readers' questions and comments have been focusing on the mutual fund aspects of their forms. A few of general interest are:

* "I've been using two Vanguard bond fund accounts that offer free checks. Will I have to pay capital gains tax on my checks?"

Every sale of shares in a bond or equity fund outside an individual retirement account (IRA) or other tax-deferred plan may result in a short-or long-term taxable capital gain (if you sell shares for more than their cost) or capital loss (if you sell them for less).

When you draw a check on any mutual fund, you cause shares to be sold. If it's on a bond fund -- instead of a money market fund, whose share price is managed to stay at $1 -- the sale can result in a gain or loss. Net long-term capital gains are taxed at up to 28 percent. Short-term gains are taxed at ordinary income rates -- up to 39.6 percent. If you have a net capital loss, you can apply up to $3,000 against other income, thereby reducing your taxable income.

* "Are reinvested dividends considered the same as purchases?"

Yes. When you buy shares of a mutual fund outside a tax-deferred account, the Internal Revenue Service does not distinguish between money from a paycheck or other sources, including reinvested dividend or capital gains distributions.

* "What are the tax implications involved in international funds such as Scudder's and Harbor's? I do my own taxes and am at the limit of what I can do. If I need to get into something more complicated than normal funds, I can't handle it."

Funds invested in foreign stocks that pay dividends -- of which your proportional share is taxable by IRS -- pay taxes on the income to foreign governments in your behalf and withhold your share of the taxes from the dividends they pay you.

(Bond interest isn't taxed everywhere; where it is, international bond funds may be managed to avoid incurring foreign taxes.)

Equity funds commonly report foreign taxes paid for you on IRS Form 1099-DIV so that you can avoid or reduce double taxation by (1) taking the taxes as a credit against the U.S. income tax you owe or (2) including them among itemized deductions against your income -- if you itemize.

Taking the credit is more complicated than reporting the deduction because Form 1116, on which you list your foreign income and taxes, is more complicated than Schedule A, on which you list your deductions -- that is, if you don't take the standard deduction.

But taking the foreign tax credit is also more beneficial since you get $1 credit for $1 of taxes. For deductions your recovery depends on your tax bracket. (If it's 28 percent, you recover 28 cents per $1.)

As with other tax questions, fund companies typically suggest you "contact your tax adviser for guidance" but the amount of money involved may be too small to justify paying an adviser just for this purpose.

(An international equity fund's yield may be only 1 percent; the taxes, one-fifth of that.) IRS instructions and staffers should be able to help.

* "I sold some fund shares in 1993. How do I determine the cost basis for tax purposes? Should I use FIFO (first in, first out)?"

IRS offers four methods to calculate the cost of shares sold so that you know how big a gain you pay taxes on -- or how big a loss you may be allowed.

These calculations can be a problem if you bought shares at various prices and times (including reinvested distributions). All are explained in "Mutual Fund Distributions" (IRS Publication 564), which you should get yearly.

FIFO, one of the four, can be advantageous if your oldest shares cost more than the price at the time of your sale, enabling you to realize a capital loss. It can be disadvantageous, however, if your oldest shares cost much less than your sales price, causing you a large taxable capital gain.

If your fund company has calculated your capital gains for you and sent you -- but not IRS -- a statement reporting them, it probably used the "single-category method" to figure your "average basis."

(Putnam will use any of the four methods, as requested by its shareholders.)

You need to study the IRS booklet to determine which of the four makes the most sense for you.

* "I used FIFO last year, but my broker says I shouldn't have done it. I don't think he was right. He says I should talk to a tax man, but I am unemployed. I can't afford to go to a tax man."

You may not need a tax man. You can get free literature not only from IRS but also from fund companies, such as INVESCO (800-525-8085), Putnam (800-752-0040), Scudder (800-225-2470), and SteinRoe (800-338-2550). Vanguard (800-876-1840) offers a more comprehensive guide for $5 plus $1.50 for shipping and handling.

While it's too late for 1993, you may want to do some investment planning for 1994 and future years. You may find funds' literature helpful for this purpose, too -- especially "Tax Considerations for Investors," offered for free by T. Rowe Price (800-547-8457).

If you're thinking of switching or adding funds, remember to bear in mind potentially taxable income and capital gains distributions.

This means weighing your net from taxable vs. tax-exempt bond funds and the prospects for high vs. low distributions among equity funds.

The Tax Analysis feature on each page of Morningstar Mutual Funds, which you may find at your library, may give you a rough idea of the potential capital gains tax costs inherent in most funds you'd consider.

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