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Bankrate's 2010 Tax Guide
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Down market could produce tax surprises

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 could find themselves in when the books close on a 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 means shareholders end up owing the Internal Revenue Service for those gains even if their fund's overall value 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

Because 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 2009 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 capital gains 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.

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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.

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