Here is a terrible idea: Sell a mutual fund and buy it right back simply to enjoy booking a profit. It might give you bragging rights, but financially it only increases your taxable income. It in no way reduces risk. There are, however, several valid reasons for selling all or part of a mutual fund.
Mutual Fund Income
Mutual funds must annually distribute to their shareholders 98 percent of ordinary earnings and 98 percent of capital gains, or pay a 4 percent excise tax on the amount not distributed, according to Kundra & Associates, a Maryland-based tax law firm. By doing so, mutual funds pay no taxes -- the tax burden passes through to shareholders. Income arises from interest and stock dividends. Capital gains stem from net trading profits. If the capital gain results from a position that the fund held for over a year, the Internal Revenue Service treats it as long-term and qualified for a tax break. Most dividends qualify for the same tax break. Paper profits do not create taxable capital gains until the mutual fund sells the profitable security.
The Effect of Taking Profits
When you profitably sell shares of your mutual fund, you immediately incur a capital gain. Short-term capital gains are those generated by the sale of shares you’ve held for a year or less. They create ordinary income that is taxable at your marginal rate. The tax rates on long-term capital gains are 20 percent, 15 percent or zero percent, depending on your modified adjusted gross income. Income from reinvested dividends and gains is considered a short-term gain even if you first bought the fund over a year ago.
Reasons to Take Profits
You might sell some or all of your mutual fund if you think markets are entering a downtrend or you find another investment more attractive. For example, if stocks look weak and bonds look strong, you might dump your stock fund and grab a bond mutual fund. You might like the market but feel disappointed with your mutual fund choice. You also might prefer to invest in a lower cost fund or one that produces fewer capital gains. A tax-efficient index fund might remedy both problems. Of course, sometimes you might need to sell a mutual fund simply because you need cash.
If you want to sell a mutual fund and are near the one-year anniversary of its purchase, it might be best to hold the shares a little longer to get long-term capital gains treatment. You might save on taxes when you take profits by selling your mutual funds at year end if you feel you have unusually large capital losses this year or will have unusually small capital losses next year. This way, you can offset more of your capital gains with losses. You might also time capital losses for similar reasons. However, if you sell a mutual fund at a loss and buy it back within 30 days, the IRS will label it a wash sale and deny the capital loss.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.