Investors buy and sell mutual funds traded on the New York Stock Exchange throughout the year. The Internal Revenue Service (IRS) assesses taxes on the proceeds of many mutual fund sales. The type of fund sold, the date the sale occurred, and the investor's income tax bracket all have an impact on the amount of tax the investor must pay.
Short Term Capital Gains
When calculating taxes, the IRS refers to the price an investor paid for a particular mutual fund share as the cost basis of that investment. Investors who own a share for less than a year, and sell it for profit, experience what the IRS calls a capital gain. This means the value of the share rose and the shareholder made a profit by selling it. The shareholder must pay ordinary income tax on the amount of the sale, minus the original cost basis. Basically shareholders are taxed on the profit, as if it were ordinary income.
Long Term Capital Gains
Shareholders who sell mutual fund shares for profit, having held the shares for more than one year, receive long-term capital gains. The gains are the difference between the cost basis, or purchase price, and the sale price of each share. The IRS does not treat long term gains as ordinary income. Instead, the IRS requires shareholders to pay capital gains tax on long-term gains. As of 2010, capital gains tax amounts to 15 percent. For many investors, ordinary income tax rates on short-term gains exceed the long-term capital gains tax.
Mutual funds contain stocks that pay dividends, and bonds that pay interest, and both dividends and interest accumulate inside the funds. Generally, funds pay these accumulated earnings as dividends towards the end of the year. Since dividends are paid from the fund, the share price decreases after the dividend distribution occurs, and shareholders are taxed on the distribution. People who buy shares just before the distribution date don't benefit from the dividend accumulation, because it occurred before they bought the shares. Their share price falls when the distribution occurs, and they end up paying tax on what effectively amounts to a return of principal.
People who sell mutual funds within qualified retirement accounts, such as 401(k)s, don't have to pay taxes in the year the sale occurred, unless they actually withdraw the funds from the retirement account.
Some investors choose to have dividends from mutual funds reinvested and used to buy new shares of the same fund. These re-investments add to the investor's cost basis, but people often overlook this when calculating capital gains, and overpay their taxes, because they only deduct their initial investment from the sales price.