Investing and Taxes

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If there’s one certainty in investing, it’s taxes. Everyone pays them, and regardless of the prevailing market conditions, they have the potential to considerably eat away at the earnings on your investments.

Fortunately, by understanding the tax issues associated with mutual fund investments and incorporating a few tax-wise strategies alongside a well-thought-out financial plan, investors can potentially limit their tax liabilities and, in turn, enhance their long-term wealth.

In the following pages, you will read about the taxes associated with capital gains and dividend distributions, strategies for minimizing your tax bill and tips for tax efficient investing, including an overview of tax-advantaged accounts.

How Mutual Fund Taxes Work

Mutual funds are professionally managed investments that pool money from a number of investors and invest in stocks, bonds, money market instruments and other securities according to a predetermined investment objective.

Fund ownership is denoted in shares, and each share represents investors’ proportionate ownership of the fund and the distributions made by the fund. There are tax consequences associated with distributions received from a mutual fund and in connection with selling fund shares.

Distributions

Mutual fund distributions can come in the form of capital gains or dividends.

Capital Gains

At the end of each year, mutual funds are generally required to distribute net realized capital gains to shareholders. Realized gains occur when an asset that has appreciated in value is sold, making the profit taxable. Unrealized gains are gains on paper only and are not taxed until they are distributed to shareholders (at which time they would become “realized”). A fund can post a large annual return and not trigger taxable capital gains for its shareholders if it continues to hold its winners; conversely, a fund may make distributions of realized capital gains to its shareholders even when posting small or negative returns in a given year.

There are two basic categories of capital gains distributions: short term, in which the assets are held one year or less, and long term, in which assets are held longer than 12 months. Tax rates on the two categories differ. Short-term capital gains are taxed at ordinary income tax rates (up to 35%). Long-term capital gains currently are taxed at a rate of either 15% or 0%, depending on income. The 0% rate applies to taxpayers with annual taxable income in the 15% or lower tax bracket. The lower tax rates on long-term capital gains apply in tax years 2009 and 2010, but will sunset in 2011, unless new tax legislation is enacted before December 31, 2010.

Dividends

Mutual funds are required to distribute to their investors any income that exceeds expenses on an annual basis. Funds typically earn income from dividends and interest on the securities held in their portfolios. In most cases, funds pay to shareholders all of their net investment income (dividends and interest less fund expenses), if any, in the form of dividends at least once a year. These dividends are taxed as ordinary income.

To the extent a fund receives qualifying dividends from its investment in stocks, all or a portion of its ordinary income distribution may be classified as a qualifying dividend. Qualifying dividends currently are taxed at the lower long-term capital gains rates (15% or 0%). As with the tax treatment of long-term capital gains, the lower tax rates on qualifying dividends are set to expire in 2011.

Other Important Points About Fund Distributions

  • Distributions may be received in cash or automatically reinvested in additional fund shares. Either way, they are taxable.
  • Reinvested dividends or capital gains distributions are considered purchases of additional mutual fund shares and are added to fund shares’ aggregate cost basis.
  • Some distributions-if classified as a return of capital or as tax-exempt interest dividends from a municipal bond fund-may not be taxable.
  • Be aware that once a distribution is made, the fund’s net asset value will decline by the amount of that distribution, hence the term “ex-dividend” date-the date the fund first trades without the dividend.

Selling Fund Shares

The value of mutual fund shares may increase or decrease, thereby generating either capital appreciation or depreciation for shareholders. If fund shares are sold, this capital appreciation or depreciation is realized, creating either capital gains (in the case where the sale price of fund shares is greater than the purchase price) or capital losses (where the sale price is lower than the purchase price). As noted previously, long-term capital gains currently are taxed at 15%, or 0% for the two lowest tax brackets. Short-term capital gains are taxed at ordinary income tax rates (up to 35%).

Special Consideration: The AMT

The Alternative Minimum Tax (AMT), which was created to prevent higher-income parties from using tax benefits to pay little or no tax, is affecting an increasing number of taxpayers today. It may apply to those who have substantial tax deductions or derive considerable income from incentive stock options, certain private activity municipal bonds and other types of tax-sheltered investments. At year-end, your fund company or broker will notify you of the percentage of fund dividends, if any, that was derived from tax preference items for AMT purposes.

Keeping Track

Shareholders receive regular statements summarizing activity in their mutual fund accounts. While statements provide helpful information, they are not official tax reports; these normally arrive in January or early February.

Investors should retain their transaction confirmation statements, which show complete information for each mutual fund purchase, sale or exchange, including the date, the number of shares, price per share, dollar amount and any fees or commissions in each transaction. Investors are wise to talk with their financial and tax professionals before making any trade, particularly one that may involve both ordinary income and capital gains taxes.

Identifying Sold Shares

Calculating the capital gain or loss when selling a portion of your shares can be complicated, particularly when these shares have been accumulated over time. To establish this figure, you or your tax adviser first must choose from a number of accounting methods to identify the cost basis of any shares you sell. These techniques include first-in, first-out (FIFO), average cost (single category and double category) and specific identification.

First-In, First-Out (FIFO)

Using this method, the first shares bought in an account are considered the first shares sold. Unless you specify that you are using one of the other methods, the Internal Revenue Service (IRS) will assume you are using FIFO.

Average Cost

  • Single-category average cost. Averages the purchase prices of all shares bought.
  • Double-category average cost. Calculates the average purchase price of long term shares and short-term shares separately to determine whether to pay taxes at the lower capital gains rate or ordinary income tax rate.

Once either one of the average cost methods is chosen for a particular fund, shareholders may not change to another method at a future date without permission from the IRS.

Specific Identification

Specific identification allows you to specify the shares you want to sell at the time of the sale. Your cost basis is the original purchase price of those shares or the price(s) of shares received as a result of reinvestment of fund distributions.

Managing Your Tax Bite

Famed economist John Maynard Keynes once said, “The avoidance of taxes is the only intellectual pursuit that carries any reward.” That may be bold, but no one should overpay on their taxes. Following are a few strategies that can help minimize the tax bill:

  • Offset capital gains with capital losses. You may be able to use capital losses from one investment to offset gains from another. Gains can be offset dollar for dollar. If your losses exceed your gains, you can deduct up to $3,000 in losses from ordinary income in one year. Excess losses greater than $3,000 can be carried forward to reduce taxes on gains and ordinary income in future years.Note that long-term losses are first applied to long-term gains and short-term losses are first applied to short-term gains. Therefore, it may be preferable to focus on offsetting short-term gains first, since they currently are subject to a higher tax rate than long-term gains.
  • Consider mutual fund gifting. In lieu of a cash contribution, you can transfer to a charitable organization mutual fund shares that are scheduled to receive a large distribution. In doing so, you avoid paying capital gains taxes on gifts valued up to 30% of your adjusted gross income.
  • Exchange with care. Carefully consider the tax implications of exchanging shares of one fund for shares of another. Just like any sale, an exchange triggers a taxable event, unless the funds are held in a tax-deferred account.
  • Avoid short-term capital gains. Short-term gains currently are taxed at a higher tax rate than long-term capital gains. So, consider holding your investments for at least one year and a day. This way, should you sell them at a gain, you will be taxed at the lower long-term capital gains tax rate (in tax years 2009 and 2010). For active traders, it is important to monitor your short- and long-term capital gains exposure and to rebalance your portfolio annually.
  • Include dividends in the cost of your investment. When you automatically reinvest dividends, you increase the aggregate cost of your shares (the cost basis). Forgetting to include dividends in the cost of your investment could cause you to pay taxes on gains you never realized.
  • Review withholding elections. If considering a substantial sale of fund shares, review your current withholding from wages or your estimated tax payments. Underpayment could result in an IRS penalty. Consider increasing your withholding to accommodate the taxes you will owe, or make an estimated tax payment to cover the additional taxes
  • Avoid wash sales. If you would like to sell an investment at a loss, but believe that investment still has upside potential, wait more than 30 days to repurchase it. IRS rules prohibit investors from recognizing a loss on the sale of a security that is purchased within 30 days. This is known as the “wash sale rule.” If you are concerned that the security may increase in value during the time that you do not own it, consider buying additional shares at least 30 days prior to the sale. Of course, be aware that you will have increased exposure to this security until you execute the sale for tax-loss purposes.
  • Be mindful of mutual funds with year-end distributions. If you sell a portion of your mutual fund shares for a loss, and the fund pays a year-end distribution within 30 days, which you reinvest, that will constitute a wash sale. Additionally, if you buy shares in a fund before it makes a year-end distribution, the distribution you receive will be subject to taxation regardless of the length of time you owned the shares. The fund’s net asset value will also decline by the amount of the distribution.
  • Consider mutual funds that invest in dividend-paying stocks. When a mutual fund receives qualifying dividends from stock that it holds, that distribution is passed on to shareholders, who can apply the lower tax rates.
  • Use carried losses to your advantage. Consider investing in mutual funds that have large capital loss carry forwards but whose recent performance and future prospects seem relatively attractive. The benefit: Should the funds continue to outperform, future capital gains distributions may be minimized because of the capital loss carry forwards. Speak with your financial professional about this strategy.

Municipal Bond Funds

Municipal bond mutual funds are one type of investment that can help minimize the effects of taxes. The interest generated by the municipal bonds in which the fund invests is free from federal tax and, in some cases, state and local taxes as well. The same is true of distributions representing net investment income from municipal bond funds (although any capital gains distributions are taxable). Municipal bond funds usually offer a slightly lower yield than taxable bond funds. However, due to their tax-advantaged nature, they may actually generate more after-tax income than a taxable fund with a higher yield.

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Tax-Advantage Investing

One of the easiest ways to maximize the after-tax returns on your investments is through tax-advantaged savings opportunities. It is often advisable to contribute the maximum percentage allowed to your qualified retirement accounts to best prepare for your future financial security, and also to minimize your present-day tax bite.

Traditional IRA

An IRA is a tax-deferred retirement account that permits you to set aside a portion of earned income each year, with earnings on investment exempt from taxes until withdrawals begin at age 59½ or older. Contributions to a traditional IRA, as well as the earnings and gains from these contributions, accumulate tax-free until withdrawn. In addition, contributions to a traditional IRA are tax deductible, up to $5,000 for those aged 49 and under, or $6,000 for those 50 and older in tax years 2009 and 2010. (Withdrawals of IRA funds prior to age 59½ trigger a tax penalty of 10% of the distributions received, unless certain exceptions apply. Withdrawals are also subject to taxation at the ordinary income tax rate, unless the individual made non-deductible contributions, which have already been taxed.)

Roth IRA

A Roth IRA provides no deduction for contributions, but instead offers a benefit that is not available for any other form of retirement savings: zero taxation of investment earnings on funds withdrawn after the investor reaches age 59½ and a five-year holding period is met. (Until both requirements are fulfilled, withdrawals of earnings are taxable, and may be assessed a 10% penalty as well.) Unlike the traditional IRA, a Roth does not require taking minimum distributions after age 70½.

In addition to a traditional IRA, there are specialized versions of tax-deferred accounts, such as Education IRAs, Simplified Employee Pension IRAs and SIMPLE IRAs. Speak with your financial professional to learn more.

401(k)

A 401(k) is a type of defined-contribution retirement plan offered by an employer and funded by employee contributions. Contributions are made from pre-tax income and the funds grow tax-free until withdrawn. It is almost always advisable to contribute the maximum allowable amount to your account, thereby also maximizing any matching employer contributions. 401(k) plans offer a number of advantages:

  • Because 401(k) contributions are made with pre-tax dollars, the amount of tax paid out of each paycheck is reduced.
  • Both employee and employer contributions (if applicable), as well as capital appreciation, grow tax-free until withdrawn, so the effect of consistent contributions over long periods is enhanced.
  • The employee controls the direction of future contributions and/or current savings, allowing the flexibility to work within an overall budget.
  • If provided, a company match of contributions is akin to an additional form of compensation that merely requires employee participation.
  • Unlike a traditional pension plan, all vested dollars held in a 401(k) can be moved from one company to another (or to a rollover IRA) if the participant changes jobs.

The Roth 401(k) became available in 2006. Like the Roth IRA, contributions are made after tax and earnings grow tax free — i.e., no taxes are due at withdrawal if all terms are met. If your employer offers the Roth 401(k), you may elect to redirect all or part of what you can contribute to a traditional 401(k) to the Roth.

Qualified Retirement Plan Contribution Limits for Tax Years 2009 and 2010
Contribution Limit Catch-Up Contribution
Traditional*/Roth† IRA $5000 $1000
401(k)/403(b)/457(b) 16,500 5,500
SIMPLE plan 11,500 2,500

529 Plans

529s are tax-advantaged college-saving plans sponsored by individual states to help finance higher-education expenses. Among its many benefits, the plan allows contributions to grow tax-deferred, and distributions are tax-free when the assets are used for qualified higher-education expenses.‡ 529 plans generally allow for a maximum total account contribution limit of $200,000 or more per beneficiary, depending on the plan. Notably, 529 plans are state-sponsored but available nationally, meaning you are not restricted to plans sponsored by your state of residence.§

Step-Up in Basis

Beneficiaries may get a break on inherited investments under a feature of the tax law known as a “step-up” in cost basis. Essentially, this is the readjustment of the value of an appreciated asset upon inheritance. A step-up in basis means the beneficiary does not need to use the original owner’s cost basis to calculate his own. Instead, the cost basis is stepped up to the fair market value at the time the deceased owner’s estate is valued. In this way, the beneficiary’s capital gains tax is minimized because it is not based on the increase in value from the deceased’s original purchase price.

Estate Planning Considerations

Stretch IRAs

Stretch IRAs allow account owners to lengthen the time during which their assets can accumulate on a tax-deferred basis. This strategy is designed to help minimize the tax liability for beneficiaries. For example, an account owner names his or her spouse as beneficiary. When the account owner dies, the spouse rolls the assets to his or her IRA and names a younger beneficiary. When this younger beneficiary inherits the IRA, the balance is paid based on the younger person’s life expectancy. This process extends both the length of time that withdrawals can be taken and the period in which the assets grow tax-deferred beyond the lifetime of the original account owner. (To help ensure the success of this strategy, beneficiaries must understand their part in extending the life of the inherited IRA.)

Gifting

To reduce your taxable estate, you can make cash gifts up to $13,000 ($26,000 for married couples) per recipient annually without incurring a gift tax. Contributions are considered completed gifts and are no longer part of the donor’s estate. Contributions to a 529 account qualify for the annual gift-tax exclusion. In the case of 529 gifting, the donor may be eligible to make a special election that permits federal gift-tax-free contributions of $65,000 ($130,000 for couples) for each beneficiary in just one year (provided no additional gifts are made to the same beneficiary during a five-year period).||

Glossary of Terms

Alternative Minimum Tax

Mechanism designed to ensure high-income taxpayers pay some minimum amount of tax, regardless of deductions, credits or exemptions, by adding certain tax-preference items back into adjusted gross income.

Automatic Reinvestment

A service whereby an investor’s income and capital gains distributions are automatically reinvested in a mutual fund through the purchase of additional shares, thus expanding total holdings.

Capital Gains or Losses

The difference between the adjusted cost basis of an investment and the amount realized when shares are sold.

Capital Gains Distributions

Payments (usually annual) to mutual fund shareholders of capital gains the fund has realized on the sale of portfolio securities. Distributions of capital gains are classified as either long or short term, which currently are taxed at different rates. These distributions can be reinvested to purchase additional fund shares.

Cost Basis

The purchase price of an investor’s shares, which may be calculated in a few ways, including FIFO, average cost and specific identification.

Distributions

Payments by a mutual fund to shareholders in the form of a dividend, long- or short-term capital gains or return of capital, which may create personal income tax obligations.

Dividend

A distribution from a fund’s net income to its shareholders. Dividends can be reinvested to purchase additional shares in a mutual fund account.

Municipal Bonds

Debt obligations issued by state and local governments to fund projects such as the construction of roads, schools and hospitals. Interest generated by municipal bonds is free from federal tax and, sometimes, from state and local taxes as well.

Mutual Fund

An investment that pools the money of numerous investors and invests that money in a number of securities on their behalf according to a predetermined investment objective.

Net Asset Value (NAV)

The current price of a mutual fund share, calculated by taking the fund’s total assets less liabilities and dividing the remainder by the number of outstanding shares.

Qualified Retirement Plan

A retirement plan that is eligible for special tax consideration. IRAs and 401(k)s are qualified retirement plans.

Qualifying Dividend

Dividends paid by a US corporation or a qualified foreign corporation that are eligible for the same favorable tax rate that applies to long-term capital gains (15% or 0%, depending on income and when the qualifying dividend is received).

Work With Your Financial Professional. For more information about tax-efficient investing or any of the subjects addressed herein, please speak with your financial professional. For specific tax-related questions, consult your tax adviser. Before you invest in a 529 savings plan, request a program description from your financial professional and read it carefully. The program description contains more complete information, including investment objectives, charges, expenses and risks of investing in the plan, which you should consider before investing. You also should consider whether your home state or your designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s 529 plan.

* Deductibility is phased out for active participants in an employer-sponsored retirement plan. Phase-out thresholds depend on marital status and income level. † Ability to make contributions is phased out for taxpayers with an adjusted gross income (AGI) above certain thresholds. ‡ Earnings on non-qualified withdrawals are subject to applicable income taxes and a potential 10% federal penalty tax. § Contributors and beneficiaries do not need to be residents of the state to participate. However, one should consider the potential tax advantages of investing in a home state program when choosing among available 529 programs.
|| This election is made on IRS Form 709, US Gift Tax Return, for the calendar year in which the contribution is made. Individuals who take advantage of the five-year accelerated gifting and die within the five-year period will have to include a portion of the gift in the estate valuation.

Any information presented about tax considerations affecting your financial transactions or arrangements is not intended as tax advice and cannot be relied upon for the purpose of avoiding any tax penalties. Shenouda does not provide tax, accounting or legal advice. You should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with your personal professional advisers. The preceding is designed to provide general information about tax-advantaged investing strategies and does not constitute legal or tax advice. It is not intended to offer specific investment recommendations. Investing involves risk. You should contact your financial professionals and tax advisers about your particular situation before making important investment decisions.

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