Taxable mutual funds

[prherr]

I have two balanced mutual funds in taxable accounts that have done well but have taxable distributions each year.  What are good ways to handle these funds now that I am retired?  I have considered selling them and paying capital gains, opening a charitable distribution account, or taking distributions each year and paying the tax as I go, as I have been doing for several years.

[MarionH · Accepted solution]

The taxability of dividends from mutual funds depends on the type of dividend you receive, as reported on Form 1099-DIV. Dividends can be categorized into the following types, each with different tax implications:

Types of Dividends and Their Tax Implications

1. Ordinary Dividends:

   • Taxed at your regular income tax rate, just like wages or other income.
   • Dividends from mutual funds that do not qualify as "qualified dividends" are categorized as ordinary dividends.

2. Qualified Dividends:

   • Taxed at the preferred long-term capital gains rates, which are typically lower than ordinary income tax rates.
   • To be classified as "qualified," you must meet a specific holding period for the mutual fund shares (holding the shares for more than 60 days during a 121-day period surrounding the dividend payment).

3. Tax-Exempt Dividends:

   • Not subject to federal income tax but may still be subject to state or local taxes.
   • These dividends are typically from mutual funds that heavily invest in tax-exempt municipal bonds.

4. Return of Capital:

   • Not taxed in the year you receive them. Instead, they reduce your cost basis in the mutual fund shares.
   • This results in a higher capital gain (or smaller loss) when you eventually sell the mutual fund shares.

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Tax-Planning Options for Dividends

If you're looking to minimize taxes on dividends, you have several options:

• You can receive taxable dividends and reinvest those funds into tax-free investments, such as municipal bonds, Roth IRAs, or 529 plans. For more information on tax-saving investment opportunities, check out this article: Do You Pay Taxes on Investments?.
• You could consider moving your mutual fund investments into tax-advantaged options like those mentioned above. However, this process may result in immediate tax consequences, such as capital gains tax, depending on how and where the investments are moved. It is recommended to consult with a financial advisor for specific guidance on available options and potential tax implications.

Properly managing the tax treatment of mutual fund dividends can help you maximize your after-tax return while aligning your financial strategy with your goals.

@prherr 

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[Katie-P · Accepted solution]

There are many things to consider with this situation, such as:

• your other sources of income (social security, required minimum distributions, pensions, etc) 
• your need for the funds
• charitable intent (were you already going to give money to charity anyway?)
• your estate plans

If the distributions are causing your tax bracket to jump up, from say 12% to 22%, then you may want to consider selling. But if the distributions are not causing a tax rate increase, then it may not be as lucrative from a tax standpoint to sell, especially if you don't really need the money from the sale. You also would want to pay attention to long-term capital gains tax brackets every year. It wouldn't be wise to pay 20% in capital gains taxes in one year if you could spread the sales out and pay 0% or 15% on the same amount of money.

You may also want to consider holding onto the investments and gifting them in your estate. The beneficiaries would receive a step up in basis, which would lessen or eliminate capital gains if they sold upon receipt.

You mentioned charity. If you already have the intent to give to charity, you could do so via a donor-advised-fund and avoid paying any capital gains taxes.

These are just some things to consider. You definitely have options, and you don't have to do the same thing every year. It sounds like you are approaching the decision with the right mindset. There is no one best answer; it all depends on what your goals are. I hope this helps! Great job on making such valuable investments!

[MarionH]

In addition, your dividends can be used to fund a donor-advised fund (DAF).  This approach might be appealing if you value the long-term planning flexibility offered by a DAF.

Separately, you could fund a DAF with cash/dividends or appreciated stock to receive an immediate tax deduction while planning for future charitable gifts. This strategy can be especially advantageous in years when your income is high.

While DAFs offer significant benefits, there are some potential disadvantages to consider. For example:

• You may lose direct control over donated assets, as the sponsoring organization makes the final decisions on grants.
• Various fees charged by the sponsoring organization can reduce the total amount available for charitable purposes.
• Contributions to a DAF are irrevocable, meaning funds cannot be withdrawn once donated.
• Funds can potentially remain in the DAF for extended periods without being distributed, delaying their impact.