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Investing in a mutual fund can be less risky than buying individual securities. If you buy a stock mutual fund, for example, you will typically own an interest in hundreds of different stocks. The sheer diversity of your portfolio minimizes the damage that any one individual stock can cause. However, mutual funds can and do lose money for investors. When it's time to file your taxes, you can use that loss to your advantage.
Mutual Fund Gains
If you sell a mutual fund at a profit, you have a capital gain. Mutual funds generate two types of capital gains. If you sell your mutual fund shares at a higher price than you paid, you have a realized capital gain. If your fund generates profits on its own investments and distributes them to you in the form of a payment, you have a distributed capital gain. You can use the losses on your mutual fund to offset any capital gains you have on mutual funds in your portfolio, whether they were realized or distributed.
Other Capital Gains
The Internal Revenue Service doesn't discriminate when it comes to capital gains. You can use any capital losses, such as those from your mutual fund, to offset any capital gains, whether or not they came from mutual funds. For example, if you sell a stock at a higher price than you paid, you have a capital gain on that stock. You can use your mutual fund loss to offset that gain, just like you would if your gain was from a mutual fund.
Generally, you can't use capital losses to offset ordinary income, such as the money you make from your salary or wages. However, there's an exception if your mutual fund losses exceed all of your capital gains. The IRS allows you to apply up to $3,000 in excess losses to your ordinary income. This can be particularly advantageous since ordinary income is often taxed at a higher rate than capital gains. As a result, the ability to offset some of your ordinary income can result in greater tax savings than if you simply matched up your capital gains and losses.
One of the main tax advantages of a capital loss is that it doesn't expire. If you've already offset all your capital gains for the year, plus the $3,000 in ordinary income you're allowed, your losses don't simply vanish. The IRS lets you carry those losses forward for use in future years, into perpetuity. If you have $30,000 in excess losses, you can offset $3,000 in ordinary income every year for the next 10 years, unless you use some of those losses to offset capital gains.
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