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Bankrate's 2009 Tax Guide
Investments
Investing wisely is key to your wealth-building strategy. Keeping your gains from the IRS is, too.
 
Mutual fund distributions
Down market could produce investor tax bills


In the investment world, taxes are the price you pay for success. And sometimes that success -- and the accompanying tax bill -- come as a total surprise.

That's the predicament that some mutual fund shareholders found themselves in when the books finally closed on last year's turbulent market. Fund managers sell assets throughout the year, passing along a portion of any gain from those sales to the individual shareholders as capital gains distributions. That meant the shareholders ended up owing the Internal Revenue Service for these gains even though their fund's overall value may have dropped dramatically.

But there is a silver lining for long-term investors. While they can't avoid taxes on stock gains, those who buckle into the market roller coaster for an extended ride will find their patience can offer them a lower tax bill.

Special tax rates for some gains
Since stock investments aren't guaranteed money makers, tax lawmakers decided to reward the risk-taking. Capital gains receive more favorable tax treatment than regular income, like wages or interest earned on bank accounts. Depending on your tax bracket and on how long you hold an asset before selling it, you could pay substantially less on capital gains money than you would pay on the same amount received as salary.

Regular income is divided over six tax brackets, with the 2008 rates ranging from 10 percent to 35 percent. When it comes to investment income, however, taxpayers will face lower tax rates.

Most investors face a maximum rate of 15 percent. Some lower tax bracket investors will owe no tax on long-term holdings.

But this is the government, so there's a catch: The lower capital gains tax rate applies to long-term capital gains. This means you must hold your investments for more than a year before selling. If you sell earlier, any gain is classified as short-term and is taxed at the regular income rates.

Remember: the cut-off is more than a year. If you sell on the 365th day, any gain is short-term. So when you're contemplating selling, keep an eye on the calendar. If you determine you can wait to sell without hurting your holdings' overall value then do so. But don't ever hold onto a stock that you think might nose dive just to avoid paying short-term capital gains taxes.

When you do cash in that hot stock, for either a long- or short-term gain, you pay for your success by filing a Schedule D along with Form 1040.

Losing timing control
While the date-of-sale rules are critical in determining whether you'll owe the lower, long-term capital gains tax, sometimes the timing choice is not yours. This is the case for mutual funds.

With an individual stock, you decide when you buy and sell, giving you some control over the stock's tax implications. But with mutual funds, some assets are sold throughout the year and a portion of any gain is then passed along to you, the shareholder, as a capital gains distribution. For most funds, the largest distribution to fund holders comes at the end of the year. It doesn't matter whether you get a check for these distributions or reinvest them in the fund; they are still taxable.

The IRS considers capital gain distributions as long-term and gives them more favorable tax treatment, but that doesn't totally ease the pain when the taxable amount is unexpectedly large. Such is the case for many market players during a bull market. One investor, for example, found one year that his mutual fund portfolio produced distributions totaling more than $25,000.

The good news: He bragged about his fund-picking prowess. The bad news: He had to pay taxes on the unexpected windfall. While paying the 15 percent, long-term capital gains rate was certainly better than forking over even more taxes at the higher bracket into which the investments pushed him, the surprise tax bill still caused a substantial dent in his bank account.

Fund moves are tax sales
Don't overlook the tax consequences of reallocating your mutual fund holdings. Some investors are shocked to discover that when they move assets from one fund to another, even within the same fund family, the IRS considers this selling.

If there's a gain associated with this fund shift, it's taxable at either the short- or long-term rates (or a combination of both) depending on when you bought the first fund shares.

So pay attention to your funds and all your portfolio management actions throughout the year. This will give you time to prepare for or ease any impending tax burden.

More importantly, it could help prevent any penalties that might come from not paying enough taxes in payroll withholding contributions. To avoid a tax underpayment penalty caused by capital gains -- either via stock sales or fund distributions -- you might want to adjust your salary withholding or make estimated tax payments when you see the value of your portfolio increasing.

-- Updated: March 18, 2009
 
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