When you make money from a mutual fund, you must report your gains as income and pay taxes on them. You can also report mutual fund losses and write them off of your taxable income. When you write off losses, you must follow some guidelines that affect how much of a tax break you get and when you get it.
Pay Tax When You Sell
When your mutual fund goes down in value and you continue to hold on to the shares you own in the fund, you do not claim the loss on your taxes. This kind of loss is designated as an “unrealized loss” in investment jargon. You technically have not lost the money yet because you haven’t sold your shares and “realized” your loss.
If you hold your shares of a mutual fund longer than one year and then sell them for less than you bought them, you have a long-term loss. You must keep this kind of loss separate from short-term losses, and designate it on your tax return. The reason for this is that long-term gains and losses receive a different tax rate than ordinary income. The tax rate is typically lower for long-term mutual funds than for ordinary income. This means you must write off your long-term losses against long-term gains. For example, if you had long-term gains of $5,000 on one mutual fund, and a long-term loss of $3,000 on another, you would indicate a net long-term gain of $2,000 on your tax return.
If you hold mutual fund shares one year or less and then sell them for a loss, you have a short-term loss. You designate short-term losses on your tax return because these represent a different tax savings than long-term losses. Short-term losses come off your ordinary income. Since your ordinary income gets taxed at a higher rate than long-term gains, you save more money by using short-term losses to reduce your ordinary taxable income. For example, if you show ordinary income of $50,000 and have $5,000 in short-term mutual fund losses, you reduce your taxable income to $45,000.
Special Rule on Distributions
At the end of the year, many mutual funds make distributions to shareholders. These are long-term distributions. If you hold shares for six months or less and sell them right after a long-term distribution, you can only count part of your loss as a short-term loss. You only get the short-term loss for any amount greater than the distribution. For example, if you sell shares you held less than six months and take a $5,000 short-term loss, but you had a $1,000 distribution on those shares, you only get a $4,000 short-term loss to write off of your taxes. You can find out what the limits are on IRA deductions by reading IRS Publication 590.
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