Investment decisions, particularly regarding long-term investments such as mutual funds, shouldn't be dictated solely be tax consequences. However, there may be instances in which you'd prefer to avoid a taxable capital gains distribution from your fund. Since these payouts are never surprises, you can take steps to avoid them. Consider the unintentional taxes or penalties you may trigger by selling a fund to determine if avoiding the capital gains distribution makes sense.
Mutual funds don't always make capital gains distributions. Growth funds, which invest in stocks and other capital appreciation securities, are generally more likely to make capital gains payouts than other types of funds, such as income funds. However, any fund can generate a gain. By law, funds must pay out these gains to shareholders. The typical gains distribution is made at the end of the year. Funds always publish the timing and estimated payout of any gains well in advance of the actual date. You'll generally be contacted by your broker or the fund company itself if you're going to receive a gain. You can also find this information at any reputable financial news source.
You'll have to sell your fund well in advance of the actual pay date to avoid a capital gains distribution. Investors that own a fund as of the record date of the distribution will receive the payout, even if they sell the fund between the record date and the distribution date. To avoid getting hit with the gain, you'll have to sell the day before the "ex-dividend" date, which is two business days before the record date.
If you sell your mutual fund before the ex-dividend date, you may avoid the fund's distribution, but you may end up with an even larger tax problem. Any time you sell mutual fund shares, you'll have to calculate the gain or loss on your trade and report it to the IRS. If you have a gain, you'll owe tax. If you've held the fund for one year or less, the effects could prove costly. Short-term gains can be taxed at up to 39.6 percent federally as of 2013, while long-term gains have a top rate of 20 percent.
Another pitfall to avoid when selling fund shares is a wash sale. Selling a fund at a loss and buying it back within 30 days is considered a wash sale, which disallows your use of the loss. While you can use most capital losses to offset capital gains, the loss in a wash sale instead gets added back to the cost of your new shares, negating the loss. This could prove to be an expensive way to avoid a capital gains distribution on your fund.
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