No matter how much money they make, nobody likes to pay taxes. But the worst thing in the world is paying taxes when you never actually earned the income you're getting taxed on.
Unfortunately, that's exactly what happens every year around this time. With many mutual funds paying large taxable distributions at the end of the year, you have to be extremely careful if you decide to make big investments in December. Otherwise, you could end up with a big tax bill that you don't really deserve.
This Tax Is Out of Your Control
When you own stocks, the way you get taxed is pretty simple to understand. In most cases, if a stock pays a dividend, then you'll include that income on your tax return for the year and pay tax on it. But no matter how much the stock price goes up, you'll never pay taxes on the gains until you decide to sell the stock. That puts you in full control of when you'll pay capital gains taxes and is an incredibly valuable way to take advantage of tax deferral even without a tax-favored retirement account like an IRA or 401(k).
For reasons only the IRS fully understands, however, mutual fund shares follow different rules. With mutual funds, tax rules look inside the fund to determine whether you owe taxes on income. So if the fund receives dividend or interest income, then the fund is required to pay it out to you, and you'll pay tax on it. But even worse, if the fund buys or sells investments inside its portfolio, then you'll end up paying any capital gains that result -- even if you never sold your shares. In fact, even if you do what millions of investors do and reinvest your mutual fund distributions to buy more fund shares, you still have to pay tax on that money.
The Loophole Congress Left Open
The sad thing is that all this could have been a thing of the past by now.
Last year, Congress came close to enacting tax law changes that would have eliminated the unfair treatment of long-term mutual fund shareholders. But lawmakers got bogged down in what many considered more pressing tax issues, and so tax reform for mutual funds got pushed aside once more.
Without that relief, you're largely on your own to protect yourself from big fund distributions.
Three Ways to Avoid an Unfair Tax
It's important to remember that all of these issues only affect mutual funds in regular taxable accounts. If you own a mutual fund in an IRA or 401(k), you don't have to worry about any of this. However, if your funds are outside of these accounts, here are some ways you can potentially save yourself a tax mess:
If you're considering making an investment in a mutual fund this month, see if it's planning to make a large year-end distribution. If it is, hold off on buying new fund shares until after the fund makes that distribution. Because the tax consequences depend entirely on who was a shareholder at the time the fund pays out its income, you'll avoid any taxes by waiting.
Similarly, if you're thinking about selling shares that you've owned for a long time, think about selling them before a big distribution. By doing so, you may be able to avoid what would have been interest or short-term capital gains income -- taxable at a potentially much higher rate -- and instead get favorable long-term capital gains treatment.
However, if you sell shares you've owned for less than a year, you may actually want to take the distribution. That's because by selling, all of your gain will count as short term and incur a high tax rate. But if you take the distribution, some of that gain may effectively get transformed into dividend or long-term capital gains, which enjoy a better rate.
For good or ill, you have to stay aware of esoteric tax laws like this if you want to avoid paying the IRS more than you need to. By making the right moves with your mutual fund investing, you can save yourself from unnecessary higher taxes.
Motley Fool contributor Dan Caplinger doesn't mind taxes but hates dumb taxes. You can follow him on Twitter here.