Unless you hold your mutual funds in a tax-advantaged account like an IRA, you have to pay taxes every year on your income and capital gains distributions. Exchanging your fund for another one may allow you to avoid the year-end capital gains distribution that many funds make. However, you may still face taxes on the actual exchange of your fund.
Exchange As Sale
The Internal Revenue Service considers a mutual fund exchange the sale of one fund and the purchase of another. You will be responsible for capital gains tax if you exchange your fund at a profit, just like you would in an outright sale. Your holding period will determine how much you owe. If you exchange your fund one year or less after you bought it, you'll pay taxes at the short-term capital gains rate, which is the same as you pay on your ordinary income. If you held the fund for longer than one year, you can take advantage of the long-term capital gains rate, which tops out at 15 percent as of 2012.
Taxes on Income
You're liable for taxes on any dividends or interest payments you receive from a mutual fund before you exchange or sell it. For example, if you exchange your fund in July, you're responsible for the taxes on any payments made to you before July. If the fund continues to make distributions after you exchange it, you're not liable for any additional tax, since you would not receive any of those dividends. However, you will be responsible for taxes on any income you receive from your new mutual fund.
If you want to avoid paying taxes on a fund's year-end distribution, it's not enough to exchange out of the fund before the payment date of that distribution. Fund companies publish the so-called "ex-dividend" date before any year-end payments are made, and this is the important date when it comes to your taxes. The ex-dividend date is the day the fund trades "without the dividend" -- meaning, if you haven't sold or exchanged the fund before that date, you will be the one receiving the payment. Even though you haven't received the distribution, exchanging a fund after the ex-dividend date means you are liable for the taxes on that payment.
Exchanging a losing mutual fund could end up saving you money in taxes. Just like you're responsible for the capital gains if you exchange your fund at a profit, you're also entitled to the benefit of your capital losses if your fund has gone down in value. The IRS allows you to use capital losses to offset any of your other investment gains, and up to $3,000 in ordinary income. Because an exchange is considered a sale for tax purposes, you could exchange your losing fund into another to capture the loss. Rather than paying tax on the exchange, you'd actually be lowering your tax bill.
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