Capital Gains Rules for Mutual Funds

There is no snapshot for you to follow taxes in a mutual fund.stock market analysis screenshot image by .shock from Fotolia.com

Mutual funds avoid the need to pay capital gains taxes by passing on gains to shareholders each year. Not only do taxes eat away at your investment returns, but also taxes force you to pay a gain on an asset you may not be liquidating or using. Understanding the rules for capital gains on mutual funds will prepare you for the annual tax consequence and allow you to possibly offset some gains with losses.

Short Term Capital Gains

Short-term capital gains are gains from the sale of a security within one year of its purchase. Fund managers may buy XYW stock in February and sell it in November for a gain. This short-term capital gain is passed on to the fund investors. Some funds have very aggressive managers who buy and sell frequently--sometimes the same security--creating a large short-term consequence. Keep in mind that the fund can be down in value but you may still have a capital gain. From 1988 to 2010, the tax rate on short-term capital gains has been as high as 39.6 percent and as low as 28 percent, according to the Tax Foundation.

Long-term capital gains are gains for securities held for longer than one year. Just as with short-term gains, the mutual fund passes the taxes on to its shareholders. Again, you may own the mutual fund with no distributions but find yourself with a capital gain at the end of the year resulting from the fund manager selling a bond or stock held for more than 12 months. Long-term capital gains max out at 15 percent for higher income households but can be as low as zero percent for lower tax brackets in 2010.

When you redeem shares of a mutual fund, you generate a taxable event. If the mutual fund has appreciated over the time you owned it, you will realize a capital gain. The cost basis of the capital gain is the net asset value, or price, on the date you purchased it. Your gain basis is the NAV on the day you sell it. Remember that the taxes generated from the redemption do not include the long-term or short-term gains realized through fund management. Depending on whether you held the fund for more than 12 months, your gains may be treated as long-term or short-term gains as well.

Securities don't just generate capital gains; you are able to offset gains with capital losses. You can offset all gains. If your losses exceed gains, you are limited in the amount of loss you can claim. Married couples filing jointly can claim up to an additional $3,000 capital loss; single filers can claim up to $1,500 for the year. If you still have additional losses, you may carry the amount forward to later years.