Regarding investments, capital gains taxes can be one of the most important but often misunderstood concepts.

As a savvy investor, you’ll want to understand how capital gains from mutual funds are taxed so you’re prepared for tax season and making smart financial decisions.

This blog post will cover the basics so you know what to look out for when investing in mutual funds—so read on to learn more about how capital gains taxes apply to your mutual funds!

Understanding Capital Gains Tax

When investing in mutual funds, capital gains taxes are one of the most important considerations—but they’re also some of the most misunderstood. Understanding how these taxes work is important so you can make smart financial decisions and be prepared for tax season.

Capital gains taxes are a tax on profits from investments that have increased in value since they were purchased. When you sell a mutual fund with a profit—also known as a “capital gain”—you must pay taxes on your profits.

The amount of tax you owe depends on several factors, including whether the mutual fund is taxable or non-taxable, how long it was held, and what type of investment it was (short-term or long-term).

If you held the mutual fund for more than a year, it is considered a long-term investment and will be taxed at either 0%, 15%, or 20% – depending on your income level.

On the other hand, if you held the mutual fund for less than one year, it’s considered a short-term investment, and you’ll be taxed at your ordinary rate (usually between 10% and 37%).

Who Is Affected by Capital Gains Tax?

Regarding capital gains taxes, anyone who owns a mutual fund is subject to paying them. This can include individual investors, retirement funds, or other investment vehicles.

Capital gains taxes apply when an investor sells a security such as a stock, bond, or mutual fund for more than what they paid for it—the price difference known as the “capital gain” is taxed at the end of each tax year.

One important point about capital gains tax is that the amount you must pay will depend on your specific financial situation and how long you hold the asset before selling it.

Long-term capital gains (an asset held for more than one year) are taxed at lower rates than short-term capital gains (less than one year).

The Two Types of Capital Gains Taxes

There are two types of capital gains taxes that investors need to be aware of:

• Ordinary income
• Preferential tax rates

Ordinary income

This capital gains tax applies to any income earned throughout the year, including wages, investments, and other sources. The rate for ordinary income is calculated by taking your total taxable income and applying the applicable tax rate from the brackets listed in the IRS Tax Rate Schedules.

Preferential tax rates

This type of capital gains tax is lower than the ordinary income rate and applies to any capital gains earned from investments held for more than one year. The taxation rate depends on your tax bracket, with the highest rates applying to those in higher brackets.

It’s important to keep track of all capital gains throughout the year, as they are added together and taxed at either the ordinary income rate or preferential rate, depending on the length of time each investment was held.

How Mutual Funds Are Taxed?

Mutual funds are taxed in two main ways: dividends and capital gains. Dividends are a share of the profits that a mutual fund earns, which are then distributed to its shareholders, and these are generally taxed at ordinary income tax rates.

Capital gains occur when you sell your shares in the fund for more than what you paid. Any amount you make above your original investment is considered a capital gain, and this amount is subject to the tax rate for capital gains.

Calculating Capital Gains Taxes on Mutual Funds

Regarding capital gains tax, you will need to pay taxes on any profits made from the sale of your mutual funds.

To calculate the capital gains tax owed for mutual fund investments, you have to subtract your original purchase price (the cost basis) from the sale price of the fund.

If the result is positive, you owe taxes on the profits you made, known as capital gains.

The amount of capital gains taxes you owe will depend on your tax bracket and the length of time that you held the fund before selling.

Generally speaking, if you owned a mutual fund for one year or less before selling it, any proceeds are classified as a short-term capital gains and the taxed at the same rate as your ordinary income.

However, if you held onto a mutual fund for more than one year before selling it, any proceeds are classified as a long-term capital gains and the taxed at a lower rate.

For example, say that you purchased 100 shares of ABC Fund at $10/share in January 2018 and sold them for $15/share in April 2019. To determine the capital gains taxes you owe, subtract your cost basis of $1,000 (100 x $10) from the sale price of $1,500 (100 x $15).

This means that you made a profit of $500—so you would owe taxes on this amount at whatever rate applies to your tax bracket.

However, since you held the mutual fund for over a year, this would be classified as a long-term capital gains and thetaxed at a lower rate.

How to Reduce Your Tax Liability on Mutual Funds?

Contribute to a Retirement Account

Contributing to a 401(k) or IRA is one of the most effective ways to reduce your tax liability on mutual funds. This is because any contributions to these accounts are tax-deferred, meaning you will only have to pay taxes once you withdraw them later in life.

Utilize Tax Loss Harvesting

Tax loss harvesting is a strategy that involves selling investments that are losing money to offset any capital gains taxes you may owe. This is because when an investment loses value, it can be used to reduce your taxable income and thus lower the amount of taxes you pay.

Take Advantage of Low Capital Gains Rates

As mentioned, long-term capital gains (profits made on investments held for more than one year) are taxed at a lower rate than short-term capital gains (profits made on investments held for less than one year).

Therefore, try to hold mutual funds for at least one year before selling them to take advantage of the lower tax rates.

By understanding how capital gains taxes apply to your mutual funds and taking advantage of the strategies above, you can reduce your tax liability and maximize the potential returns on your investments!

FAQs

What is a capital gains tax?

A capital gains tax is a tax imposed on the profits, or "gains," from investments. It's paid when you sell your investment for more than you originally paid. The amount of the gain determines how much you will need to pay in taxes.

How are capital gains taxed when investing in mutual funds?

Mutual funds are subject to the same rules as other investments regarding capital gains taxes. When you sell your shares of a mutual fund, any profit you make is considered a capital gain and must be reported on your taxes.

How do I calculate my capital gains taxes for mutual funds?

To calculate your capital gains taxes, you’ll first need to determine the gain or loss (the difference between what you originally paid and the amount you sold your shares for). This will then be used to figure out how much tax is owed.

Conclusion

When investing in mutual funds, it's important to understand how capital gains taxes apply. This blog post has provided an overview of all the basics—so you know what to look for when making financial decisions. With a better understanding of capital gains taxes, you can make smarter investments and be prepared for tax season!