How do I Offset Mutual Fund Distributions?
With certain exceptions, mutual fund distributions create taxable income. The source of the distributions can be interest, dividends or capital gains. Unless interest stems from tax-free municipal bonds, the Internal Revenue Service taxes it at your marginal rate. Dividends and capital gains may qualify for lower rates. If you wish to reduce the tax bite on mutual fund distributions, you can attempt to offset them with losses and other deductions.
Capital Gains and Losses
Long-term capital gains rates apply to property you hold for more than one year. However, the IRS considers all capital gains distributions from mutual funds as long-term. In 2013, the long-term capital gains rate is 20 percent for single taxpayers with more than $400,000 in modified adjusted gross income. The threshold is $450,000 for married couples filing jointly. For smaller incomes, the rate is 15 percent if your tax bracket is 28 percent or higher; otherwise, the gains are tax-free. Capital losses offset capital gains and up to $3,000 of ordinary income. You can carry unused capital losses forward to future years. You can offset mutual fund capital gains distributions by selling other securities for a capital loss before the end of the year. You can also apply any previous year’s capital losses you’ve carried forward.
Most corporate dividends qualify for capital gains tax rates. To qualify, the dividends must come from corporations that pay taxes on their income. Foreign company stock dividends qualify if you can easily trade the shares in the United States. For you to take advantage of the lower rates, you must hold the mutual fund shares for at least 61 days. Like taxable interest, nonqualified dividends are ordinary income. You can use excess capital losses to offset some ordinary income. You can also offset ordinary income with tax deductions.
You can follow various strategies to increase your tax deductions and offset ordinary income. For example, you can contribute to charities and non-profit institutions that offer tax deductions. Another source of deductions is a traditional IRA and similar arrangements that offer a deduction for contributions. In 2013, you can contribute the lesser of your gross income and $5,500 to an IRA. The maximum increases to $6,500 if you are age 50 or older. Other plans offer larger contribution limits. Your financial adviser can help you explore different ways to generate deductions and lower your taxable income.
Be sure to add commissions and fees to the cost basis of mutual fund shares you sell -- this will reduce your gain or increase your loss. Many deductions must overcome a 2 percent hurdle rate -- you deduct expenses in excess of 2 percent of your adjusted gross income. Fees for investment advice and expenses fall into this category. You might also consider ways to reduce mutual fund distributions or their tax bite. In addition to using tax-free municipal bond funds, you can lower your tax bill by investing in tax-advantaged or index funds, which limit their trading activity and thus realize fewer capital gains. Distributions you receive inside an IRA are tax-deferred or tax-free, depending on the type of account.
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