An individual retirement account provides a tax shield for any investments you put into it. You don't have to pay any tax on your investment earnings until you take the money out of your IRA. If you own mutual funds outside the protective wrapper of an IRA, you'll have to pay taxes on your income and gains in the year they occur.
A capital gain occurs when you sell any asset, including a mutual fund, for a higher price than you originally paid. If you sell a mutual fund outside of an IRA, you'll have to report that transaction to the Internal Revenue Service when you file your taxes. The type of gain you take can have significant ramifications on how much tax you'll owe. If you owned your mutual fund for longer than a year, you have a long-term capital gain, which qualifies for a special tax rate. As of 2012, the top long-term capital gains tax rate was just 15 percent. If you sell your fund one year or less after you buy it, your gain is short term and is taxable at the same rate as the rest of your income. For 2012, the highest ordinary income tax rate was 35 percent.
Capital Gains Distributions
Even if you don't sell any shares of your mutual fund, you might still be responsible for paying capital gains tax. Mutual funds often make year-end distributions of capital gains to shareholders, reflecting the profits the fund manager has harvested over the course of the year. If you receive a capital gains distribution, you'll have to pay tax on it just as if you had sold shares of the fund at a profit yourself. This tax is due even if you don't take the money in cash but rather reinvest the distribution back into the fund.
Just as with capital gains, the law requires mutual funds to pass any income they earn to their investors. This can result in a significant tax liability for shareholders owning funds outside of an IRA, as income distributions are typically taxed at ordinary income rates. Some funds may pay out qualified dividends, which benefited from the lower capital gains tax rates as of 2012. However, any income distributions, except those generated by tax-free municipal bonds, result in a tax liability for non-IRA owners. Even stock mutual funds, which are typically purchased to generate capital gains, can sometimes make taxable income distributions.
Most mutual fund companies allow you to exchange funds within the same family without paying an additional sales charge or commission. From the perspective of the IRS, however, exchanging mutual funds is the same as selling one fund and buying another. If you have a profit on your original fund, you'll owe capital gains tax even if you exchange it rather than selling it outright.
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