If you’ve invested in mutual funds, you have probably realized capital gains and dividends from your investments over the years.
Strategy: Don’t overpay your tax liability when you sell mutual fund shares. Despite improvements in digital record keeping, it’s still easy to inadvertently pay tax twice on mutual fund distributions when you’ve reinvested proceeds.
For example, say you bought mutual fund shares four years ago for $10,000. The fund paid out $500 in capital gain dividends each year for a total of $2,000. You elected to have these amounts reinvested in more shares of the fund. Then you sold all your shares in 2019 for $15,000.
Because you paid $10,000 and sold the shares at $15,000, you might think you had a $5,000 gain…right? Wrong. Your tax basis in the shares is $12,000 (original cost of $10,000 + $2,000 of reinvested dividends that you paid tax on). So, your taxable gain is actually $3,000 ($15,000 – $12,000). If you inadvertently report a $5,000 gain, you’re effectively paying tax twice on the $2,000 reinvested dividends. Note that the federal income tax rate on long-term capital gains and qualified dividends is 15% for most folks (20% for high-income investors).