The Reference Section

A collection of wealth improvement articles


Surprise! The Mutual Fund Tax Trap
Last Reviewed: 12/03/2016

Too often taxpayers receive a tax surprise at year-end due to actions taken by a mutual fund they own. What can add insult to injury is the unsuspecting taxpayer who recently purchases the shares in a mutual fund only to be taxed on their recent investment. How does this happen and what can you do about it?

Tax surprises

Towards the end of each year, many mutual funds pay a dividend to the holders of record as of a set date. The fund might also distribute funds deemed as capital gains based upon buying and selling activity that takes place in the fund throughout the year. This can create many problems:

  • Right back at you. If you purchase shares in a mutual fund just before a distribution of dividends, part of your purchase includes the dividends that are effectively paid right back to you. Not only will the asset value of your recently purchased shares in the mutual fund go down after the distribution, but you will owe tax on a distribution that is effectively your own money!
  • Kiddie tax surprise. Many taxpayers use mutual funds in their child’s name to take advantage of their lower-tax rates. By keeping their child’s unearned income below $1,050 - $2,100 the tax is low or non-existent. A surprise dividend or capital gain could expose much of this unearned income to the parent's higher tax rate.
  • The $3,000 loss strategy. Each year you may take a net of up to $3,000 in investment losses. With correct tax planning your losses can offset high rates of income tax. But first these losses need to offset capital gains. If you receive a surprise capital gain, you could be reducing the effectiveness of this tax strategy.

What to do

Here are some ideas to help reduce this mutual fund tax surprise.

  • Limit year-end activity. Plan your mutual fund moves with this year-end surprise in mind. Consider reviewing and rebalancing your funds at the beginning of the year to avoid fund purchases just prior to dividend distributions.
  • Research your mutual funds. If you wish to avoid a year-end surprise do a little research on your mutual funds to anticipate what will happen with the fund. Check out the historic trends of your funds to determine which are most likely to issue a surprise 1099 DIV or a 1099 B (capital gain/loss).
  • Use the knowledge to your benefit. If you like a fund and it has a practice of creating taxable events each year, consider investing in these funds within a retirement account. That way the tax implications can be part of your retirement planning.

No one likes a surprise at tax time. The best course of action regarding your mutual funds is to consult with an expert who can help you navigate the options that are best for you.