How much tax should you pay on reinvested capital gains distributions from your mutual funds?
Nothing. At least that’s the idea behind a bill introduced in July to the U.S. House. Investors would not be taxed until they sold the fund shares bought with the distributions.
But just in case the bill doesn’t pass – similar ones have stalled in committee in recent years – you can take some steps to minimize this tax on your own.
For investors with taxable accounts, the House proposal, and a companion introduced in the Senate in May, would be a valuable change. Currently, distributions from mutual funds are taxed in the year received, even if they are automatically reinvested in the fund. This can create huge headaches at tax time.
When a fund manager sells a holding, such as a stock or bond, the original purchase price is subtracted from the sale price to produce a capital gain or loss. Late in the year, all the sales are tallied, and if there is a net gain, it is paid to fund investors, usually in November or December.Rather than pocket the payment, most shareholders have the distributions reinvested. But they have to pay tax on the distribution unless the fund is held in a tax-deferred account like a 401(k) or IRA. The taxable amount is reported in the 1099 form that comes from the fund company in January.
In some years, this involves a lot of money. The biggest distributions ever came in 2007, when ordinary investors with taxable accounts received $147 billion, according to the Investment Company Institute, the fund industry’s trade group. That was caused by the big stock market gains of the previous two years. Last year the comparable figure was just $35 billion, reflecting the much weaker market.
In some cases the distributions are whoppers. In 2007, for example, the American Century Ultra Fund (Stock Quote: TWCUX) made capital gains distributions equal to about one-third of the share price.