Q.: I have some money market mutual funds as well as some stock funds that have gone way up in value. Now I'm starting to make withdrawals for the first time. How will I be taxed?
A.: Fund withdrawals and tax questions aren't as mystifying as they seem at first if you remember a basic principle: Your earnings should be taxed only once.
The real trick is to determine just what constitutes earnings, such as interest, dividends and capital gains.
With taxable money market funds, this isn't too hard. Money markets are designed as "safe" places to stash cash. The fund invests in very short-term securities, such as government and corporate bonds, that mature in only a few months or less.
The funds are designed to always have a share price of $1. That means you don't have to worry about capital gains tax, which is charged on the profit realized when you sell an investment for more than you paid. With a money market fund, you pay a dollar when you buy, you get a dollar when you sell so there's no capital gains tax.
People put money into money market funds to earn interest while keeping cash safe and "liquid," or easy to withdraw.
These interest payments are taxed as income, just as you'd be taxed on interest payments from a bank savings account. Each January, the fund company should send you a 1099 form reporting the amount of interest you earned the previous year. You have to pay income tax on this even if you had the money reinvested in more money-market shares.
If you withdrew money from the fund during the year which means selling shares don't worry. Since there's no profit on money market shares, there's no capital gains tax to report on your return. The withdrawal merely reduced the amount of interest you earned during the rest of the year.
With stock funds, it's not so simple. That's because the share price, or net asset value, fluctuates day by day. Net asset value is the value of all the assets, such as stocks, bonds and cash, owned by the fund, divided by the number of fund shares. If the net value of the holdings go up when stock prices rise, for instance the net asset value rises.
Withdrawing money from the fund means selling shares. If the shares sell for more than you paid, that profit, or capital gain, is taxable. The tax is applied against the profit, or difference between what you received when you sold and what you had paid.
The tax rate used depends on how long you owned the shares. If you owned them a year or less, you pay the short-term rate. If you owned them longer than a year, you pay the long-term capital gains tax rate.
Unlike the money market fund, where the tax on interest received is paid every year, this capital gains tax on the stock fund is paid only after you sell the shares.
Unfortunately, many stock funds also trigger a different tax one on annual distributions. These may be dividends paid by stocks in the fund, as well as interest earned by any cash held by the fund.
In addition, at the end of the year you may receive a capital gains distribution, which is the net profit made on assets such as stocks that the fund manager sold during the year.
The tax on all these distributions is owed even if you just had the money reinvested in more fund shares. If you are not careful, you could end up paying more tax than you owe.
You owe the tax only once. So if you paid tax on distributions that were used to buy more shares, that reinvested money should be added to the cost of acquiring shares.
Suppose you'd invested $5,000 in 100 shares, and bought another 10 shares with $1,000 received in distributions. Your "cost basis," or total purchase cost, would be $6,000, not $5,000.
That comes to $54.54 a share, not the $50 a share you paid for the first 100 shares. When you sell the shares, you need to figure the taxable gain by subtracting $54.54 from the sales price. If you subtract only $50, you'll end up paying tax again on $4.54 that was already taxed when the distributions were paid.
Obviously, it's important to keep clear records of all the additional share purchases made with distributions. Be careful about relying on the annual summaries from your fund companies as their calculations are not always accurate.